Question

Barn Yard Inc. is a wholesaler that stocks engine components and tests 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 one out of every 200 such orders is never collected. The required return is 1.8% per period.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.

Answer 1

The NPV is positive, therefore, this order can be placed.

How to calculate the NPV?

The calculation of probability of default will be:

= 1 / 200 = 0.005

We use NPV formula to find out whether the order should be filled or not

NPV = -Variable cost per unit +[(1-π)(price of equipment/1+percentage of return)]

= -$1.6 million +[(1-0.005)($1.725m/1.018)]

= -$1.6m + $1.6860

= 0.0860 million

As NPV is positive this order can be placed.

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