A Break-Even Application Because the discount percentage (d) is controlled by the firm, the key unknown in this case is the default rate (^). What is the break-even default rate for Locust Software?

We can answer by finding the default rate that makes the NPV equal to zero:

NPV = 0 = -PQ + P'Q X (d - ^)/R Rearranging things a bit, we have: PR = P'(d -^ = d - R X (1 - d) For Locust, the break-even default rate works out to be: ^ = .02 - .02 X (.98) = .0004 = .04%

This is quite small because the implicit interest rate Locust will be charging its credit customers (2 percent discount interest per month, or about .02/.98 = 2.0408%) is only slightly greater than the required return of 2 percent per month. As a result, there's not much room for defaults if the switch is going to make sense.

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