Microbiotics Currently Sells All Its Frozen Dinners Cash

Microbiotics Currently Sells All Of Its Frozen Dinners Cash On Deliver

Microbiotics currently sells all of its frozen dinners cash on delivery but believes it can increase sales by offering supermarkets 1 month of free credit. The price per carton is $70, and the cost per carton is $50. The unit sales will increase from 1,020 cartons to 1,080 per month.

a. If the interest rate is 1% per month, and all customers will pay their bills, calculate the present value of per carton. (Do not round intermediate calculations. Round your answer to 3 decimal places.)

b. If the interest rate is 1.5% per month, and all customers will pay their bills, calculate the present value of per carton. (Do not round intermediate calculations. Round your answer to 3 decimal places.)

c. If the interest rate is 1.5% per month but the firm can offer the credit only as a special deal to new customers, while old customers will continue to pay cash on delivery, calculate the present value of per carton. (Do not round intermediate calculations. Round your answer to 3 decimal places.)

Paper For Above instruction

Introduction

Microbiotics, a company specializing in frozen dinners, currently operates on a cash-on-delivery basis. Recognizing the potential to boost sales, the firm considers extending credit terms to supermarkets. This analysis evaluates the present value (PV) of extending credit under different interest rates and customer scenarios, critically informing their strategic decision-making process.

Understanding the Basics of Receivables Finance and Present Value

The core financial principle at play is the time value of money, which asserts that a dollar today is worth more than a dollar in the future due to earning capacity and risk considerations. When Microbiotics considers extending credit, it essentially provides a loan of sorts to customers, deferring receipt of cash for one month.

Calculating the PV of receivables involves discounting future cash flows at the applicable interest rate, reflecting the cost of capital or opportunity cost for the firm. As the company grants a one-month free credit, it foregoes immediate cash in favor of receivables, which can be valued by discounting the sale price minus the cost and analyzing how the increase in sales affects overall financial viability.

Scenario Analysis: Discount Rate at 1%

At a 1% monthly interest rate, the present value (PV) of a receivable that will be paid after one month is calculated as:

PV per carton = Price / (1 + interest rate) = $70 / (1 + 0.01) = $70 / 1.01 ≈ $69.306

Since all customers pay their bills, the PV per carton reflects the discounted value of the sale price, accounting for the time value of money.

Scenario Analysis: Discount Rate at 1.5%

Adjusting for an interest rate of 1.5% per month, the PV per carton becomes:

PV per carton = $70 / (1 + 0.015) = $70 / 1.015 ≈ $68.985

This slightly lower PV per carton signifies higher costs of extending credit at higher interest rates, which impacts the firm's profitability and pricing strategy.

Restricting Credit to New Customers at 1.5%

If the firm offers credit only to new customers, maintaining cash transactions with existing customers, the sales volume increases, but the credit cost is limited to the new customers' transactions. The previous calculations do not need modification since PV is evaluated per carton, regardless of customer categorization, but the total impact on cash flow changes with sales volume.

Assuming that the increase in sales from 1,020 to 1,080 cartons is primarily from new customers, the average per-carton PV remains consistent for new sales but could benefit from reduced risk or alter risk premiums in practice.

Implications and Recommendations

The findings suggest that extending credit slightly reduces the PV per carton at both interest rates. Although offering credit may increase salesVolume, the decrease in PV indicates a potential reduction in immediate cash flow value per unit. The company must weigh these trade-offs carefully, considering the increased sales volume's contribution to overall profitability despite the discounting effects.

To optimize financial outcomes, Microbiotics should consider conducting a detailed risk assessment, including potential bad debts, and explore strategies such as incremental credit limits or targeted credit offerings to minimize exposure while maximizing sales.

Conclusion

Calculating the present value of extending credit at different interest rates highlights the delicate balance between sales growth and cash flow valuation. At a 1% rate, the PV per carton is approximately $69.306, whereas at 1.5%, it's about $68.985. These insights underpin strategic decisions, emphasizing the importance of interest rates, customer segmentation, and risk management in credit policies.

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