Underwood United has been approached by a new customer who has asked the firm to extend credit for 30 days on a one-time purchase of $499.The firm's required return on receivables is 1.8 percent per month and the variable cost of the desired item is $327.What is the NPV of granting credit if the firm estimates the probability of default is 15 percent?

Question

Quizplus · Accepted Answer

First, we need to calculate the expected cash flows of granting credit:
Expected cash inflow = 0.85 x $499 = $424.15 (accounting for the 15% probability of default)
Variable cost = $327
Net cash inflow = $424.15 - $327 = $97.15
Using the formula for NPV: NPV = Net cash inflow / (1 + required return)^time period - Initial investment
The time period is 1 month, so NPV = $97.15 / (1 + 0.018)^1 - $499 = -$89.65
Since the NPV is negative, granting credit would result in a net loss for the firm. Therefore, the best choice is not to grant credit to the new customer. The only answer choice that reflects this is C.

Underwood United Has Been Approached by a New Customer Who