CHAPTER 27 APPENDIX –
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CHAPTER 28
CREDIT AND INVENTORY
MANAGEMENT
Answers to Concepts Review and Critical Thinking Questions
1. a. A sight draft is a commercial draft that is payable immediately.
b. A time draft is a commercial draft that does not require immediate payment.
3. Credit costs: cost of debt, probability of default, and the cash discount
4. 1. Character: determines if a customer is willing to pay his or her debts
3. Capital: determines the customer’s financial reserves in case problems occur with operating
cash flow
5. Conditions: customer’s ability to weather an economic downturn and whether such a downturn
is likely
5. 1. Perishability and collateral value
2. Consumer demand
4. Credit risk
6. Competition
7. Customer type
6. a. B: A is likely to sell for cash only, unless the product really works. If it does, then they might
grant longer credit periods to entice buyers.
b. A: Landlords have significantly greater collateral, and that collateral is not mobile.
7. The three main categories of inventory are: raw material (initial inputs to the firm’s production
process), work-in–progress (partially completed products), and finished goods (products ready for
8. JIT systems reduce inventory amounts. Assuming no adverse effects on sales, inventory turnover will
10. Since the price of components can decline quickly, Dell does not have inventory which is purchased
and then declines quickly in value before it is sold. If this happens, the inventory may be sold at a loss.
While this approach is valuable, it is difficult to implement. For example, Dell manufacturing plants
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
1. a. There are 30 days until the account is overdue. If you take the full period, you must remit:
Remittance = 380($130)
Remittance = $49,400
b. There is a 1 percent discount offered with a 10 day discount period. If you take the discount, you
2. The receivables turnover is:
Receivables turnover = 365/Average collection period
3. a. The average collection period is the percentage of accounts taking the discount times the discount
period, plus the percentage of accounts not taking the discount times the days until full payment
4. The daily sales are:
Daily sales = $33,100/7
5. The interest rate for the term of the discount is:
Interest rate = .01/.99
Interest rate = .0101, or 1.01%
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So, using the EAR equation, the effective annual interest rate is:
a. The periodic interest rate is:
b. The EAR is:
c. The EAR is:
6. The receivables turnover is:
Receivables turnover = 365/Average collection period
Receivables turnover = 365/33
Receivables turnover = 11.0606 times
7. The total sales of the firm are equal to the total credit sales since all sales are on credit, so:
Total credit sales = 5,750($445)
Total credit sales = $2,558,750
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The receivables turnover is 365 divided by the average collection period, so:
8. The average collection period is the net credit terms plus the days overdue, so:
Average collection period = 30 + 4
Average collection period = 34 days
9. a. The cash outlay for the credit decision is the variable cost of the engine. If this is a one-time
order, the cash inflow is the present value of the sales price of the engine times one minus the
default probability. So, the NPV per unit is:
b. To find the break-even probability of default, , we use the NPV equation from part a, set it equal
to zero, and solve for . Doing so, we get:
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c. If the customer will become a repeat customer, the cash inflow changes. The cash inflow is now
one minus the default probability, times the sales price minus the variable cost. We need to use
the sales price minus the variable cost since we will have to build another engine for the customer
in one period. Additionally, this cash inflow is now a perpetuity, so the NPV under these
assumptions is:
NPV = –$2,520,000 + (1 – .005)($2,760,000 – 2,520,000)/.029
NPV = $5,714,482.76 per unit
d. It is assumed that if a person has paid his or her bills in the past, he or she will pay his or her bills
in the future. This implies that if someone doesn’t default when credit is first granted, then they
10. The cost of switching is any lost sales from the existing policy plus the incremental variable costs
under the new policy, so:
Cost of switching = $680(1,070) + $455(1,120 – 1,070)
Cost of switching = $750,350
The benefit of switching is any increase in the sales price minus the variable costs per unit, times the
incremental units sold, so:
11. The carrying costs are the average inventory times the cost of carrying an individual unit, so:
Carrying costs = (2,590/2)($5.75) = $7,446.25
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The order costs are the number of orders times the cost of an order, so:
The economic order quantity is:
12. The carrying costs are the average inventory times the cost of carrying an individual unit, so:
Carrying costs = (675/2)($67.75) = $22,865.63
The order costs are the number of orders times the cost of an order, so:
The economic order quantity is:
The number of orders per year will be the total units sold per year divided by the EOQ, so:
13. The total carrying costs are:
Carrying costs = (Q/2) CC
where CC is the carrying cost per unit. The restocking costs are:
14. The cash flow from either policy is:
Cash flow = (P – v)Q
So, the cash flows from the old policy are:
Cash flow from old policy = ($93 – 44)(2,675)
Cash flow from old policy = $131,075
15. The cash flow from the old policy is:
Cash flow from old policy = ($283 – 223)(1,095)
Cash flow from old policy = $65,700
And the cash flow from the new policy will be:
16. If the cost of subscribing to the credit agency is less than the savings from collection of the bad
debts, the company should subscribe. The cost of the subscription is:
Cost of the subscription = $950 + $15(700)
17. The cost of switching credit policies is:
Cost of new policy = –[PQ + Q(v – v) + v(Q – Q)]
And the cash flow from switching, which is a perpetuity, is:
18. We can use the equation for the NPV we constructed in Problem 17. Using the sales figure of 2,750
units and solving for P, we get:
19. From Problem 15, the incremental cash flow from the new credit policy will be:
Incremental cash flow = Q(P – v) – Q(P – v)
And the cost of the new policy is:
20. Since the company sells 700 suits per week, and there are 52 weeks per year, the total number of suits
sold is:
Total suits sold = 700 × 52 = 36,400
And, the EOQ is 500 suits, so the number of orders per year is:
21. The cash outlay for the credit decision is the variable cost of the engine. Since the orders can be one–
time or perpetual, the NPV of the decision is the weighted average of the two potential sales streams.
22. The default rate will affect the value of the one-time sales as well as the perpetual sales. All future
cash flows need to be adjusted by the default rate. So, the NPV now is:
APPENDIX 28A
1. The cash flow from the old policy is the quantity sold times the price, so:
Cash flow from old policy = 40,000($510)
Cash flow from old policy = $20,400,000
The cash flow from the new policy is the quantity sold times the new price, all times one minus the
2. a. The old price as a percentage of the new price is:
$90/$91.84 = .98
So the discount is:
Discount = 1 – .98 = .02, or 2%
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The credit terms will be:
Credit terms: 2/15, net 30
b. We are unable to determine for certain since no information is given concerning the percentage
of customers who will take the discount. However, the maximum receivables would occur if all
customers took the credit, so:
c. Since the quantity sold does not change, variable cost is the same under either plan.
d. No, because:
d – = .02 – .11
d – = –.09, or –9%
3. a. The cost of the credit policy switch is the quantity sold times the variable cost. The cash inflow
is the price times the quantity sold, times one minus the default rate. This is a one-time lump sum,
so we need to discount this value one period. Doing so, we find the NPV is:
NPV = –15($760) + (1 – .2)(15)($1,140)/1.02
4. a. The cash discount is:
Cash discount = ($75 – 71)/$75
Cash discount = .0533, or 5.33%
The default probability is one minus the probability of payment, or:
b. Due to the increase in both quantity sold and credit price when credit is granted, an additional
incremental cost is incurred of:
Additional cost = (6,200)($33 – 32) + (6,900 – 6,200)($33)
Additional cost = $29,300
c. The credit report is an additional cost, so we have to include it in our analysis. The NPV when
using the credit reports is:
NPV = 6,200($32) – .90(6,900)$33 – 6,200($71) – 6,900($1.50) + {6,900[.90($75 – 33) – $1.50]
– 6,200($71 – 32)}/(1.00753 – 1)
5. We can express the old cash flow as:
Old cash flow = (P – v)Q
And the new cash flow will be: