Mississippi Delta, Inc. has been selling switching equipment to computer companies on net-30 terms, in which payment is expected by 30 days from the invoice date. Concerned about deteriorating collection patterns, the credit manager has divided customers into two groups for examination purposes:
Prompt pays and laggards. Prompt payors (80 percent of Mississippi Delta's customers) pay, on average, in 35 days, versus a 72-day average for the laggards. The manager wonders if the credit terms should be modified to include a 2 percent cash discount on invoices paid within 10 days. The average invoice is the same for both groups, roughly $4,000. The manager expects 50 percent of the Prompt payors to pay in exactly 10 days and the average on the other half to slip to 40 days. He thinks that 20 percent of the laggards will pay in 10 days and the average on the others will slip to 80 days. Given these forecasts, he is not sure that the lost revenue from the discount takers (who would then pay only 98 percent of the invoiced dollar amount) justifies the improved collection. The company's annual cost of capital is 11 percent.
a. Using NPV calculations, show the present value of the present collection experience.
b. Calculate the NPV of the proposed 2/10, net-30 terms.
c. Based on your net-present-value analysis, should Mississippi Delta Inc. adopt the cash discount?