Chapter 20, Problem 9QP

Evaluating Credit Policy [LO2] Air Spares is a wholesaler that stocks engine components and test equipment for the commercial aircraft industry. A new customer has placed an order for eight high-bypass turbine engines, which increase fuel economy. The variable cost is $1.6 million per unit, and the credit price is $1.725 million each. Credit is extended for one period, and based on historical experience, payment for about 1 out of every 200 such orders is never collected. The required return is 1.8 percent per period.

a. Assuming that this is a one-time order, should it be filled? The customer will not buy if credit is not extended.

b. What is the break-even probability of default in part (a)?

c. Suppose that customers who don’t default become repeat customers and place the same order every period forever. Further assume that repeat customers never default. Should the order be filled? What is the break-even probability of default?

d. Describe in general terms why credit terms will be more liberal when repeat orders are a possibility.