Credit Decision. The Branding Iron Company sells its irons for $50 apiece wholesale. Production cost

QUESTION

Credit Decision. The Branding Iron Company sells its irons for $50 apiece wholesale. Production cost is $40 per iron. There is a 25 percent chance that a prospective customer will go bankrupt within the next half year. The customer orders 1,000 irons and asks for 6 months” credit. Should you accept the order? Assume a 10 percent per year discount rate, no chance of a repeat order, and that the customer will pay either in full or not at all.
Probability of the customer going bankrupt is 25%, So, probability of non-bankruptcy is (100%-25%=75%) Again if the branding iron company sells it and the customer goes bankrupt then no possibility of revenue generation is there and hence the total loss would be the cost of production, so loss estimated = 0.25* (40*1000)= $10,000 Since discount rate is given for full year which is 10%, and since the customer might become bankrupt in the next half year, present value of the loss estimation would be =$ [(10,000)/ (1.1) ^0.5] = $9535 Now, if the customer does not become bankrupt then possibility of revenue generation is there and hence the total profit

would be; 0.75* [(1000*50) (1000-40)] $7500 Since discount rate is given for full year which is 10%, and since the customer might not become bankrupt in the next half year, present value of the profit estimation would be =$ [(7500)/ (1.1) ^0.5] = $7150 Therefore total benefit/ total loss from this scenario would be => -$9535+ $7150= -$2385 Since the company is facing a loss of $2385, hence the company should not accept the order.

ANSWER:

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