- 15 Marks
Question
Vena Plc. manufactures engineering equipment. The company has received an order from a new customer for 5 machines at N5,000,000 each. Vena Plc.’s terms of sale are 10 percent of the sales value payable with order. The deposit has been received from the new customer. The balance is payable 12 months after acceptance of the order by Vena Plc.
Vena Plc.’s past experience has been that only 60 percent of similar customers pay within 12 months. Customers who do not pay within 12 months are referred to a debt collection agency to pursue the debt. The agency has in the past had a 50 percent success rate of obtaining immediate payment once they became involved. When they are unsuccessful, the debt is written off by Vena Plc. The agency’s fee is N500,000 per order, payable by Vena Plc. with the request for service. This fee is not refundable if the debt is not recovered.
You are an accountant in Vena Plc.’s credit control department, and based on the company’s past experience and discussions with the sales and credit managers, you do not expect the pattern of payment and collection to change.
Incremental costs associated with the new customer’s order are expected to be N3,600,000 per machine; 70 percent of these costs are for materials and are incurred shortly after the order has been accepted. The remaining 30 percent is for all other costs, which you can assume are paid shortly before delivery in 12 months’ time. The company is not presently operating at full production capacity.
A credit bureau has offered to provide an error-free credit information about the new customer if the price is right.
Vena Plc.’s opportunity cost of capital is 16 percent. Ignore taxation.
Required:
a. Write a report to the Credit Control Manager evaluating, from a purely financial point of view, whether Vena Plc. should accept the order from the new customer based on the information provided. (12 Marks)
b. Comment on what other factors should be considered before a decision to grant credit is taken. (3 marks)
Answer
Report to Credit Control Manager
To: Credit Control Manager, Vena Plc.
From: [Your Name], Accountant, Credit Control Department
Date: [Insert Date]
Subject: Evaluation of New Customer Order from a Financial Perspective
a. Financial Evaluation of Customer Order
1. Order Value and Deposit
- Total Order Value: 5 machines x N5,000,000 = N25,000,000
- Deposit Received: 10% of N25,000,000 = N2,500,000
- Balance Due in 12 Months: N22,500,000
2. Payment Probability and Collection Costs
Based on Vena Plc.’s historical data:
- Probability of Full Payment within 12 Months: 60%
- Debt Collection Success Rate: 50% for remaining unpaid orders
- Expected Collection Cost: If collection is required, the agency fee is N500,000 per order.
3. Incremental Costs of the Order
- Material Costs (70%): N3,600,000 x 70% x 5 = N12,600,000 (incurred shortly after order acceptance)
- Other Costs (30%): N3,600,000 x 30% x 5 = N5,400,000 (incurred 12 months later)
- Total Incremental Cost: N18,000,000
4. Expected Cash Flow and Opportunity Cost
- Opportunity Cost of Capital: 16%
- Expected Cash Inflow:
- In Case of Full Payment: Balance N22,500,000, discounted at 16% over 12 months.
- In Case of Collection Involvement: Expected recovery of unpaid amounts at a 50% success rate, minus collection costs.
b. Additional Considerations for Credit Decision
- Credit Bureau Information: Engaging a credit bureau to verify the customer’s creditworthiness could reduce the risk.
- Customer’s Market Standing: Assessment of the new customer’s financial health and industry reputation.
- Impact on Production Capacity: While capacity is available now, large orders might affect other future orders if capacity becomes constrained.
- Potential for Long-Term Business: If this order opens doors for more consistent business, it may offset the risks.
- Tags: Credit Evaluation, Credit terms, Opportunity Cost, Payment Collection, Risk Assessment
- Level: Level 2
- Topic: Risk Management
- Uploader: Kofi