Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVII. Short−Term Financial
Planning and Management- Credit and Inventory
Management
© The McGraw−Hill^767
Companies, 2002producing the extra quantity is equal to vper unit, so the investment necessary to pro-
vide the extra quantity sold is v(Q Q).
In sum, if Locust switches, its investment in receivables will be equal to the PQ
in revenues plus an additional v(Q Q) in production costs:
Incremental investment in receivables PQv(Q Q)
The required return on this investment (the carrying cost of the receivables) is Rper
month; so, for Locust, the accounts receivable carrying cost is:
Carrying cost [PQv(Q Q)] R
($4,900 200) .02
$102 per month
Because the monthly benefit is $290 and the cost per month is only $102, the net bene-
fit is $290 102 $188 per month. Locust earns this $188 every month, so the PV of
the switch is:
Present value $188/.02
$9,400
Again, this is the same figure we previously calculated.
One of the advantages of looking at the accounts receivable approach is that it helps
us interpret our earlier NPV calculation. As we have seen, the investment in receivables
necessary to make the switch is PQv(Q Q). If you take a look back at our origi-
nal NPV calculation, you’ll see that this is precisely what we had as the cost to Locust
of making the switch. Our earlier NPV calculation thus amounts to a comparison of the
incremental investment in receivables to the PV of the increased future cash flows.
There is one final thing to notice. The increase in accounts receivable is PQ, and this
amount corresponds to the amount of receivables shown on the balance sheet. However,
the incremental investment in receivables is PQv(Q Q). It is straightforward to
verify that this second quantity is smaller by (P v)(Q Q). This difference is the
gross profit on the new sales, which Locust does not actually have to put up in order to
switch credit policies.
Put another way, whenever we extend credit to a new customer who would not oth-
erwise buy, all we risk is our cost, not the full sales price. This is the same issue that we
discussed in Section 21.5.740740 PART SEVENPART SEVEN Short-Term Financial Planning and ManagementShort-Term Financial Planning and Management
Extra Credit
Looking back at Locust Software, determine the NPV of the switch if the quantity sold is pro-
jected to increase by only 5 units instead of 10. What will be the investment in receivables?
What is the carrying cost? What is the monthly net benefit from switching?
If the switch is made, Locust gives up PQ$4,900 today. An extra five units have to
be produced at a cost of $20 each, so the cost of switching is $4,900 5 20 $5,000.
The benefit each month of selling the extra five units is 5 ($49 20) $145. The NPV of
the switch is $5,000 145/.02 $2,250, so the switch is still profitable.
The $5,000 cost of switching can be interpreted as the investment in receivables. At 2 per-
cent per month, the carrying cost is .02 $5,000 $100. Because the benefit each month
is $145, the net benefit from switching is $45 per month ($145 100). Notice that the PV of
$45 per month forever at 2 percent is $45/.02 $2,250, as we calculated.EXAMPLE 21A.1