Alex is new in town and has asked to establish credit with your ﬁrm. He would like to buy some lawn equipment today at a cost of $2,495. Your variable cost for that equipment is $1,875 and your
Monthly interest rate is 1.3 percent. You feel that Alex could become a regular customer if you grant
Him 30 days credit. You also feel that the probability of default is only 3 percent. What is the net
Present value of this decision?

Question

Quizplus · Accepted Answer

To calculate the net present value (NPV), we need to consider the cash inflows and outflows associated with the decision to grant Alex credit.

Cash inflows:
- $2,495 (payment from Alex after 30 days)

Cash outflows:
- $1,875 (variable cost for the equipment)
- $28.64 (interest cost for 30 days, calculated as $2,495 * 1.3%)
- $74.85 (expected default cost, calculated as $2,495 * 3%)

To calculate the NPV, we discount the cash inflows and outflows using the monthly interest rate:

NPV = ($2,495 - $1,875 - $28.64 - $74.85) / (1 + 1.3%)^1
NPV = $516.91

Since the NPV is positive, granting credit to Alex is a profitable decision. The best choice is D.

Alex Is New in Town and Has Asked to Establish