Analyzing the Cash vs. Credit Sales and Conducting Payback Calculation for New Equipment Purchase

Cash vs. Credit Sales Comparison

In evaluating the impact of the new equipment acquisition on cash flow, it’s crucial to consider both the expansion of the customer base through credit sales and the resulting changes in revenue collection patterns.

Currently, monthly sales for FAB Plastics’ manufactured products are $150,000, and the cost of goods sold is 70% of sales. With the new equipment, it’s anticipated that the cost of goods sold will decrease to 60%, potentially attracting more customers due to the affordability factor. Additionally, the shift from Cash On Delivery (COD) to offering credit terms of 30 days will likely lead to increased sales, projected to reach $250,000 per month.

However, the manner in which these sales are collected is crucial. The collection pattern is as follows:

• 20% of customers will pay at the end of one month
• 25% of customers will pay at the end of 2 months
• 30% of customers will pay at the end of 3 months
• 20% of customers will pay at the end of 4 months
• 5% of customers are expected to default and become bad debts

To calculate the net cash inflow from these credit sales, we need to consider the time value of money due to the cost of capital per month being 1%. By applying a discounted cash flow (DCF) approach, we can determine the present value of these future cash flows. By comparing the present value of cash inflows to the initial cost of the equipment, we can make an informed decision on whether the investment is financially viable.

Payback Calculation for New Equipment

The payback period is a crucial metric in assessing the feasibility of an investment. It indicates how long it takes for an investment to generate enough cash flows to recover its initial cost. In this case, the new equipment must pay back FAB Plastics within 4 years.

The information provided includes expected net cash flows for each year over a 5-year period:

• Year 1: $1,200,000
• Year 2: $1,200,000
• Year 3: $1,100,000
• Year 4: $1,000,000
• Year 5: $1,000,000

To calculate the payback period, you need to sum up the net cash flows until they equal or exceed the initial cost of the equipment. Based on the information given, the cost of the equipment is $4,100,000.

Performing the calculation: Year 1 + Year 2 + Year 3 + Year 4 = $1,200,000 + $1,200,000 + $1,100,000 + $1,000,000 = $4,500,000

The payback occurs sometime during Year 4 since the cumulative net cash flows at the end of Year 3 amount to $3,500,000, which is less than the initial cost. However, with the addition of the Year 4 net cash flow of $1,000,000, the cumulative cash flows exceed the initial cost, reaching $4,500,000.

Since the payback happens within the required 4-year timeframe, the equipment satisfies this condition.

Conclusion

Analyzing the expansion of the customer base through credit sales and calculating the payback period for the new equipment allows FAB Plastics to make a well-informed decision regarding the investment. The transition from COD to credit sales can potentially lead to increased revenue, but careful consideration of the collection pattern is vital. The calculated payback period demonstrates that the equipment will indeed pay itself back within the specified 4-year timeframe, contributing to the company’s profitability and growth.