Fundamentals of Corporate Finance/3e,ch14

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

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Chapter Fourteen

Credit Management


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14.1 Credit and Receivables

14.2 Terms of the Sale

14.3 Analysing Credit Policy

14.4 More on Credit Policy Analysis

14.5 Optimal Credit Policy

14.6 Credit Analysis

14.7 Collection Policy

14.8 Summary and Conclusions

Chapter Organisation


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Chapter Objectives• Understand the components of credit policy and the cash

flows associated with granting credit.• Identify the factors that influence the length of the credit

period.• Calculate the cost of forgoing discounts in credit periods.• Outline the various credit policy effects.• Calculate the cost and NPV of switching policies.• Determine the optimal credit policy.• Discuss the five Cs of credit.


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Components of Credit Policy• Terms of sale

The conditions on which a firm sells its goods and services for cash or credit.

• Credit analysis

The process of determining the probability that customers will not pay.

• Collection policy

Procedures that are followed by a firm in collecting accounts receivable.

• Accounts receivable = Average daily sales × average collection period


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Creditsale ismade

Customermails

cheque

Firm depositscheque in

bank

Bank creditsfirm’s

account

Cash collection

Accounts receivable

Time

Cash Flows from Granting Credit


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Terms of the Sale

• Credit period

The length of time that credit is granted, usually between 30 and 120 days.

• Cash discount

A discount that is given for a cash purchase to speed up the collection of receivables.

• Credit instrument

Evidence of indebtedness such as an invoice or promissory note.


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Length of the Credit Period

Factors that influence the length of the credit period include:

– buyer’s inventory period and operating cycle– perishability and collateral value of goods– consumer demand for the product– cost, profitability and standardisation– credit risk of the buyer– the size of the account– competition in the product market– customer type.


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Cost of the Credit

• 2/10, net 30 = buyer pays in 10 days to get a 2 per cent discount, or within 30 days for no discount.

• Buyer has an order for $1500 and ignores the credit period gives up $30 discount.

• The benefit obviously lies in paying early.

44.59% 1 470 1

30 1 EAR

20365


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Credit Policy Effects• Revenue effects—Payment is received later, but price and

quantity sold may increase.

• Cost effects—Cost of sale is still incurred even though the cash from the sale has not been received.

• The cost of debt—The firm must finance receivables and, therefore, incur financing costs.

• The probability of non-payment—The firm always gets paid if it sells for cash, but risks losses due to customer default if it sells on credit.

• The cash discount—Discounts induce buyers to pay early; the size of the discount affects payment patterns and amounts.


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Evaluating a Proposed Credit Policy

P = price per unit Q’ = new quantity expected to be sold

v = variable cost per unit Q = current quantity sold per period

R = periodic required return

The benefit of switching is the change in cash flow:

Q Q' v P

Q v P Q' v P

grearrangin

flowcash oldflowcash New


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Evaluating a Proposed Credit Policy

• The present value of switching is:

PV = [(P – v) × (Q’ – Q)]/R

• The cost of switching is the amount uncollected for the period plus the additional variable costs of production:

Cost = PQ + v(Q’ – Q)

• And the NPV of the switch is:

NPV = –[PQ + v(Q’ – Q)] + [(P – v)(Q’ – Q)]/R


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Example—Evaluating a Proposed Credit Policy

ABC Co. is thinking of changing from a cash-only policy to a ‘net 30 days on sales’ policy. The company has estimated the following:

P = $55 v = $32 Q = 160

Q’ = 175 R = 2%


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Solution—Evaluating a Proposed Credit Policy

4025$

1753255

policy) (new flowCash

3680$

1603255

policy) (old flowCash

Q' v P

Q v P


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25017$020

345

switching of PV

345$

1601753255

switching ofBenefit

.

R

Q Q' v P

Q Q' v P


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8930$

250178320

switching of NPV

8320$

1601753216055

switching ofCost

/RQ Q' v P Q Q' v PQ

Q Q' v PQ

Therefore, the switch is very profitable.


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Break-even Point

units877

320203255

16055

.

./

v /Rv P

PQ Q Q'

The switch is a good idea as long as the company can sell an additional 7.87 units.


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Discounts and Default Risk

ABC Co. currently has a cash price of $55 per unit. If the company extends the 30 day credit policy, the price will increase to $56 per unit on credit sales. ABC Co. expects 0.5 per cent of credit to go uncollected (). All other information remains unchanged. Should the company switch to the credit policy?

%.

d

79156$

55$56$

customerscash for alloweddiscount Percentage


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Discounts and Default Risk

803020$

02000500179016056$16055$

NPV

.

./. .

/R d QP' PQ

NPV of changing credit terms:

As the NPV of the change is negative, ABC Co. should not switch.


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The Costs of Granting Credit

• Opportunity costs are lost sales from refusing credit. These costs go down when credit is granted.

• Carrying costs are the cash flows that must be incurred when credit is granted. They are positively related to the amount of credit extended.

– The required return on receivables.– The losses from bad debts.– The costs of managing credit and credit collections.


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Optimal Credit Policy


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Credit Analysis

• Process of deciding which customers receive credit.

• One-time sale—risk is variable cost only.• Repeat customers—benefit is gained from one-

time sale in perpetuity.• Grant credit to almost all customers once as long

as variable cost is low relative to price (high markup).


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The Five Cs of Credit

• Character

Customer’s willingness to pay.• Capacity

Customer’s ability to pay.• Capital

Financial reserves/borrowing capacity.• Collateral

Pledged assets.• Conditions

Relevant economic conditions.


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Collection Policy

• Monitoring receivables:

- Keep an eye on average collection period relative to your credit terms.

• Ageing schedule—compilation of accounts receivable by the age of each account; used to determine the percentage of payments that are being made late.

• Collection procedures include:– delinquency letters– telephone calls– employment of collection agency– legal action.

Fundamentals of Corporate Finance/3e,ch14

Economy & Finance

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