Travel and Tow Trailers Inc.makes small trailers for light-duty towing behind SUVs and small pickup trucks.Its trailers typically sell for $2,500.Many of its customers have asked for credit terms to aid in purchasing the trailers.The firm's finance department has estimated the following profile for its light-duty trailers and customer base: Annual sales: 10,000 trailers
Annual production costs per trailer: $1,500
Lost sales if credit is not provided for customers: 2,000 trailers
Default rate if all customers purchase on credit: 3.00%
What is the profit if the firm has a credit policy?
A)$25,000,000
B)$9,250,000
C)$450,000
D)$8,000,000

Question

Quizplus · Accepted Answer

To calculate the profit with a credit policy, we need to first calculate the additional revenue that will be generated from customers purchasing on credit.

Additional revenue = (Lost sales due to no credit) x (Trailer price) = 2,000 x $2,500 = $5,000,000

Next, we need to calculate the cost of defaults, which will be 3% of the credit sales.

Default cost = (Default rate) x (Credit sales) = 0.03 x $5,000,000 = $150,000

Therefore, the total profit with a credit policy will be:

Total profit = Total revenue - Total cost

Total revenue = (Sales with no credit) x (Profit per trailer) + (Sales with credit) x (Profit per trailer) = (8,000 x $1,000) + (2,000 x $1,000) = $10,000,000

Total cost = (Production cost per trailer) x (Sales with no credit) + (Production cost per trailer) x (Sales with credit) + Default cost 
= ($1,500 x 8,000) + ($1,500 x 2,000) + $150,000 = $13,650,000

Total profit = $10,000,000 - $13,650,000 = -$3,650,000

This means that if the firm provides credit to its customers, it will actually incur a loss of $3,650,000. Therefore, the best choice is not to provide credit to customers.