Principles of Corporate Finance_ 12th Edition

Chapter 30 Working Capital Management 793

bre44380_ch30_787-812.indd 793 10/08/15 07:28 AM

If the probability of collection is 5/6, Cast Iron can expect to break even:

Expected profit = 5 __

6

× 200 − (^) ( 1 − __^5
6
(^) ) × 1,000 = 0
Therefore Cast Iron’s policy should be to grant credit whenever the chances of collection are
better than 5 out of 6.
So far we have ignored the possibility of repeat orders. But one of the reasons for offering
credit today is that it may help to get yourself a good, regular customer. Figure 30.5 illustrates
the problem. Cast Iron has been asked to extend credit to a new customer. You can find little
information on the firm, and you believe that the probability of payment is no better than .8.
If you grant credit, the expected profit on this customer’s order is
Expected profit on initial order = p 1 PV(REV − COST) − (1 − p 1 ) PV(COST)
= (.8 × 200) − (.2 × 1,000) = −$40
You decide to refuse credit.
◗ FIGURE 30.4
If you refuse credit, you make neither
profit nor loss. If you offer credit, there is
a probability p that the customer will pay
and you will make REV − COST; there is a
probability (1 − p) that the customer will
default and you will lose COST.
0
2 COST
Refuse credit
Offer credit Customer defaults (1 2 p)
Customer pays (p)
REV 2 COST
◗ FIGURE 30.5
In this example there
is only a .8 probability
that your customer will
pay in period 1; but
if payment is made,
there will be another
order in period 2. The
probability that the
customer will pay for
the second order is
.95. The possibility of
this good repeat order
more than compen-
sates for the expected
loss in period 1.
0

• COST 1
  Refuse credit

Refuse credit

Offer credit

Offer credit

Customer pays

p 2 = .95

Customer defaults

(1 – p 2 ) = .05

Customer defaults

(1 – p 1 ) = .2

Customer pays

p 1 = .8

0

• COST 2
  REV 1 – COST 1

REV 2 – COST 2

Period 1 Period 2