Copyright 2004 McGraw-Hill Australia... Copyright 2004 McGraw-Hill Australia 14.1 Credit and Receivables 14.2 Terms of the Sale 14.3 Analysing Credit Policy 14.4 More on Credit Polic
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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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• 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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Customer mails cheque
Firm deposits cheque in bank
Bank credits firm’s account
Cash collection Accounts receivable
Time
Cash Flows from Granting Credit
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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
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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:
( )
(P v) (Q' Q)
Q v
P Q'
v P
flowcash
oldflow
cash 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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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
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( ) ( )
4025
$
17532
55
policy)(new
flowCash
3680
$
16032
55
policy)(old
flowCash
Q' v P
Q v P
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$
020345
switchingof
PV
345
$
160175
3255
switchingof
Benefit
.
R
Q Q'
v P
Q Q'
v P
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8320
switchingof
NPV
8320
$
160175
32160
55
switchingof
Cost
/R Q Q'
v P Q
Q' v
PQ
Q Q'
v PQ
−+
−
=
=
−+
×
=
−+
=
Therefore, the switch is very profitable
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7
32 02
0 32 55
160 55
.
/
v /R
v P
PQ 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 ( π ) All other
information remains unchanged Should the company switch
to the credit policy?
$
customers cash
for allowed
discount Percentage
=
−
=
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$
02 0 005 0
0179 0
160 56
$ 160
.
/R d
Q P' 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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• 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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• Collection procedures include:
– delinquency letters
– telephone calls
– employment of collection agency
– legal action.