Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 32 pps

Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 CHAPTER THIRTY-TWO 908 C R E D I T MANAGEMENT Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 WHEN COMPANIES SELL their products, they sometimes demand cash on or before delivery, but in most cases they allow some delay in payment. If you turn back to the balance sheet in Table 30.1, you can see that for the average manufacturing company, accounts receivable constitute about one-third of its current assets. Receivables include both trade credit and consumer credit. The former is by far the larger and will, therefore, be the main focus of this chapter. Companies that do not pay for their purchases immediately are effectively borrowing money from their suppliers. Such “debts” show up as accounts payable in the purchasing companies’ balance sheets. Table 30.1 shows that payables are the most important source of short-term finance, much larger than short-term loans from banks and other institutions. Management of trade credit requires answers to five sets of questions: 1. On what terms do you propose to sell your goods or services? How long are you going to give customers to pay their bills? Are you prepared to offer a cash discount for prompt payment? 2. What evidence do you need of indebtedness? Do you just ask the buyer to sign a receipt, or do you insist on some more formal commitment? 3. Which customers are likely to pay their bills? To find out, do you consult a credit agency or ask for a bank reference? Or do you analyze the customer’s financial statements? 4. How much credit are you prepared to extend to each customer? Do you play it safe by turning down any doubtful prospects? Or do you accept the risk of a few bad debts as part of the cost of building up a large regular clientele? 5. How do you collect the money when it becomes due? How do you keep track of payments? What do you do about reluctant payers or deadbeats? We will discuss each set of questions in turn. 909 32.1 TERMS OF SALE Not all sales involve credit. For example, if you are producing goods to the customer’s specification or incurring substantial delivery costs, then it may be sensi- ble to ask for cash before delivery (CBD). If you are supplying goods to a wide variety of irregular customers, you may prefer cash on delivery (COD). 1 If your product is expensive and custom-designed, you may require progress payments as work is carried out. For example, a large, extended consulting contract might call for 30 percent payment after completion of field research, 30 percent more on submission of a draft report, and the remaining 40 percent when the project is fi- nally completed. When we look at transactions that do involve credit, we find that each industry seems to have its own particular usage with regard to payment terms. 2 These norms have a rough logic. For example, firms selling consumer durables may allow the buyer a month to pay, while those selling perishable goods, such as cheese or fresh fruit, typically demand payment in a week. Similarly, a seller will generally allow more extended payment if its customers are in low-risk businesses, if 1 Some goods can’t be sold on credit—a glass of beer, for example. 2 Standard credit terms in different industries are reported in O. K. Ng, J. K. Smith, and R. L. Smith, “Ev- idence on the Determinants of Credit Terms Used in Interfirm Trade,” Journal of Finance 54 (June 1999), pp. 1109–1129. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 their accounts are large, if the customers need time to ascertain the quality of the goods, and if the goods are not quickly resold. To induce customers to pay before the final date, it is common to offer a cash discount for prompt settlement. For example, pharmaceutical manufacturers commonly require payment within 30 days but may offer a 2 percent discount to customers who pay within 10 days. These terms are referred to as “2/10, net 30.” Cash discounts are often very large. For example, a customer who buys on terms of 2/10, net 30 may decide to forgo the cash discount and pay on the thirtieth day. This means that the customer obtains an extra 20 days’ credit but pays about 2 percent more for the goods. This is equivalent to borrowing money at a rate of 44.6 percent per annum. 3 Of course, any firm that delays payment beyond the due date gains a cheaper loan but damages its reputation for creditworthiness. You can think of the terms of sale as fixing both the price for the cash buyer and the rate of interest charged for credit. For example, suppose that a firm reduces the cash discount from 2 to 1 percent. That would represent an increase in the price for the cash buyer of 1 percent but a reduction in the implicit rate of interest charged the credit buyer from just over 2 percent per 20 days to just over 1 percent per 20 days. For many items that are bought on a recurrent basis, it is inconvenient to require separate payment for each delivery. A common solution is to pretend that all sales during the month in fact occur at the end of the month (EOM). Thus goods may be sold on terms of 8/10, EOM, net 60. This arrangement allows the customer a cash discount of 8 percent if the bill is paid within 10 days of the end of the month; otherwise, the full payment is due within 60 days of the invoice date. 4 When purchases are subject to seasonal fluctuations, manufacturers often encourage customers to take early delivery by allowing them to delay payment until the usual order season. This practice is known as “season dating.” 910 PART IX Financial Planning and Short-Term Management 3 The cash discount allows you to pay $98 rather than $100. If you do not take the discount, you get a 20-day loan, but you pay percent more for your goods. The number of 20-day periods in a year is . A dollar invested for 18.25 periods at 2.04 percent per period grows to , a 44.6 percent return on the original investment. If a customer is happy to borrow at this rate, it’s a good bet that he or she is desperate for cash (or can’t work out compound interest). For a discussion of this issue, see J. K. Smith, “Trade Credit and Information Asymmetry,” Journal of Fi- nance 42 (September 1987), pp. 863–872. 4 Terms of 8/10, prox., net 60 would entitle the customer to a discount if the bill is paid within 10 days of the end of the following (or “proximo”) month. 5 Commercial drafts are sometimes known by the more general term bills of exchange. 11.02042 18.25 ϭ $1.446 365/20 ϭ 18.25 2/98 ϭ 2.04 32.2 COMMERCIAL CREDIT INSTRUMENTS The terms of sale define when payment is due but not the nature of the contract. Repetitive sales to domestic customers are almost always made on open account and involve only an implicit contract. There is simply a record in the seller’s books and a receipt signed by the buyer. If you want a clear commitment from the buyer, before you deliver the goods, you can arrange a commercial draft. 5 This works as follows: You draw a draft ordering payment by the customer and send this draft to the customer’s bank together with the shipping documents. If immediate payment is required, the draft is termed a sight draft; otherwise, it is known as a time draft. Depending on whether it is a sight or a time Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 draft, the customer either pays up or acknowledges the debt by adding the word accepted and his or her signature. The bank then hands the shipping documents to the customer and forwards the money or the trade acceptance to you, the seller. 6 You may hold the trade acceptance to maturity or use it as security for a loan. If your customer’s credit is for any reason suspect, you may ask the customer to arrange for his or her bank to accept the time draft. In this case, the bank guarantees the customer’s debt. These bankers’ acceptances are often used in overseas trade; they have a higher standing and greater negotiability than trade acceptances. If you are selling goods overseas, you may ask the customer to arrange for an ir- revocable letter of credit. In this case the customer’s bank sends you a letter stating that it has established a credit in your favor at a bank in the United States. You then draw a draft on the customer’s bank and present it to your bank in the United States together with the letter of credit and the shipping documents. The bank in the United States arranges for this draft to be accepted or paid and forwards the documents to the customer’s bank. If you sell goods to a customer who proves unable to pay, you cannot get your goods back. You simply become a general creditor of the company, in common with other unfortunates. You can avoid this situation by making a conditional sale, whereby title to the goods remains with the seller until full payment is made. The conditional sale is common practice in Europe. In the United States it is used only for goods that are bought on an installment basis. In this case, if the customer fails to make the agreed number of payments, then the goods can be immediately re- possessed by the seller. CHAPTER 32 Credit Management 911 6 You often see the terms of sale defined as “SD-BL.” This means that the bank will hand over the bill of lading in return for payment on a sight draft. 7 Price discrimination, and by implication credit discrimination, is prohibited by the Robinson-Patman Act. 32.3 CREDIT ANALYSIS Firms are not allowed to discriminate between customers by charging them different prices. Neither may they discriminate by offering the same prices but different credit terms. 7 You can offer different terms of sale to different classes of buyers. You can offer volume discounts, for example, or discounts to customers willing to accept long-term purchase contracts. But as a rule, if you have a customer of doubtful standing, you should keep to your regular terms of sale and protect yourself by restricting the volume of goods that the customer may buy on credit. There are a number of ways to find out whether customers are likely to pay their debts. For example, you are likely to have more confidence in those existing customers that have paid promptly in the past. For new customers there are three broad sources of information about their creditworthiness. You can seek the views of a specialist credit analyst, you can look at the information embedded in the firm’s security prices, or you can use the firm’s financial statements to make your own assessment. Specialist Credit Analysts The simplest way to assess a customer’s credit standing is to seek the views of a specialist in credit assessment. For example, in Chap- ter 24 we described how bond rating agencies, such as Moody’s and Standard and Poor’s, provide a useful guide to the riskiness of the firm’s bonds. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 Bond ratings are usually available only for relatively large firms. However, you can obtain information on many smaller companies from a credit agency. Dun and Bradstreet is by far the largest of these agencies and its database contains reports on more than 10 million companies. Credit agencies usually report the experience that other firms have had with your customer. Alternatively, you may be able to get this information by checking with a credit bureau or by contacting the firms directly. You can also ask your bank to un- dertake a credit check. It will contact the customer’s bank and ask for information on the customer’s average balance, access to bank credit, and general reputation. Security Prices In addition to checking with a credit agency or your bank, it may make sense to check what everybody else in the financial community thinks about your customer’s credit standing. Does that sound expensive? It isn’t if your customer is a public company. For example, you can learn what other investors think by comparing the yield on the firm’s bonds with the yields on those of other firms. (Of course, the comparison should be between bonds of similar maturity, coupon, etc.) You can also look at how the customer’s stock price has been behaving. A sharp fall in stock price doesn’t mean that the company is in trouble, but it does suggest that prospects are less bright than they were formerly. In Chapter 24 we saw how information on security prices can be used to put a figure on the chances of default. Companies have an incentive to exercise their option to default when the value of their assets is less than the amount of their debt. So, if you know how much the value of the firm’s assets may fluctuate, you can estimate the probability that the asset value will fall below the default point. In Chapter 24 we looked at an example of how one consulting firm, KMV, uses this market-based approach to estimate default probabilities. Financial Statements Security price data may not be available for many customers, and in these cases you will need to rely on the customers’ financial statements to make your own assessment of their credit standing. In Chapter 29 we saw how managers calculate a few key financial ratios to measure the firm’s financial strength. Firms that are highly leveraged, illiquid, and unprofitable generally don’t make dependable customers. If you have a large number of customers, it may be useful to combine different financial indicators into a single measure of which companies or individuals are most likely to default. For example, if you apply for a credit card or a bank loan, you will be asked various questions about your financial position. The information that you provide is then used to calculate an overall credit score. One widely used system, designed by the consultancy firm Fair Isaacs, takes account of five factors: (1) How promptly the applicant has paid in the past (35 percent of score); (2) how much debt of each type is outstanding (30 percent of score); (3) the length of the applicant’s credit history (15 percent of score); (4) the number of credit cards and re- cently opened credit accounts that the applicant has (10 percent of score); and (5) the mix of regular credit cards, store cards, and margin accounts (10 percent of score). Applicants who fail to make the grade on the score are likely to be refused credit or subjected to more detailed analysis. Suppose you want to devise a scoring system that will help you to decide whether to extend credit to small businesses. You suspect that there is an above- average probability that firms with a low return on assets and a low current ratio 912 PART IX Financial Planning and Short-Term Management Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 will default on their debts. 8 To test this, you take a sample of past loans and construct a scatter diagram showing for each borrower the return on assets and the current ratio (see Figure 32.1). Those businesses that repaid their loans are shown by a blue x; the ones that defaulted are shown in burgundy. Now try to draw a straight dividing line between the two groups. You can’t completely separate them, but the line in our diagram keeps the two groups as far apart as possible. (Note that there are only three blue x’s below the line and three burgundy ϩ’s above it.) This line tells us that if you wish to discriminate between the good and the bad risks, you should give 10 times as much weight to the current ratio as you give to return on assets. The index of creditworthiness is You minimize the degree of misclassification if you predict that applicants with Z scores over 15 will pay their debts and that those with Z scores below 15 will not pay. 9 In practice you do not need to consider only two variables, nor do you need to estimate the equation by eye. Multiple-discriminant analysis (MDA) is a straightfor- ward statistical technique for calculating how much weight to put on each variable to separate the creditworthy sheep from the impecunious goats. 10 Index of creditworthiness ϭ Z ϭ return on assets, percent ϩ 10 1current ratio2 CHAPTER 32 Credit Management 913 0 Return on assets, percent 21 18 15 3 6 9 12 0.5 1.0 1.5 Current ratio x x x x x x x x x x x x x x x x + + + + + + + + + + + + FIGURE 32.1 The black x’s represent a hypothetical group of firms that subsequently repaid their loans; the burgundy ϩ’s represent those that defaulted. The sloping line discriminates between the two groups on the basis of return on assets and current ratio. The line represents the equation Z ϭ return on assets ϩ10(current ratio) ϭ 15 Firms that plot above the line have Z scores greater than 15. 8 The current ratio is the ratio of current assets to current liabilities. It is commonly used as a measure of the company’s ability to lay its hands on cash. See Chapter 29. 9 The quantity 15 is an arbitrary constant. We could just as well have used 150, in which case the Z score is 10 MDA is not the only statistical technique that you can use for this purpose. Probit and logit are two other potentially useful techniques. These estimate the probability of some event (e.g., default) as a function of observable attributes. Z ϭ 101return on assets, percent2 ϩ 1001current ratio2 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 Edward Altman has used discriminant analysis to come up with the following index of creditworthiness: 11 Those companies with a Z-score of less than 1.20 were predicted to go bankrupt. Companies with Z-scores between 1.20 and 2.90 were hovering in the grey area between decline and recovery. Updated and refined versions of Altman’s Z-score model are regularly used by banks and industrial companies. We wish we could show you one of these recent versions, but they are all top secret. A company with a superior method for identifying good and bad borrowers has a significant leg up on the competition. 12 Credit scoring systems should carry a health warning. When you construct a risk index, it is tempting to experiment with many different combinations of variables until you find the equation that would have worked best in the past. Unfor- tunately, if you “mine” the data in this way, you are likely to find that the system works less well in the future than it did previously. If you are misled by the past successes into placing too much faith in your model, you may refuse credit to a number of potentially good customers. The profits that you lose by turning away these customers could more than offset the gains that you make from avoiding a few bad eggs. As a result, you could be worse off than if you had pretended that you could not tell one customer from another and extended credit to all of them. Does this mean that you should not use credit scoring systems? Not a bit. It simply implies that it is not sufficient to have a good credit scoring system; you also need to know how much to rely on it. That is the topic of the next section. ϩ.42 1shareholders’ equity2 total liabilities ϩ 1.0 sales total assets Z ϭ .72 1net working capital2 total assets ϩ .85 1retained earnings2 total assets ϩ 3.1 1EBIT2 total assets 914 PART IX Financial Planning and Short-Term Management 11 EBIT is earnings before interest and taxes. Z-score models for predicting bankruptcy were originally developed in E. I. Altman, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,” Journal of Finance 23 (September 1968), pp. 589–609. The equation cited here comes from E. I. Altman, Corporate Financial Distress, John Wiley, New York, 1983. 12 When a British bank laid off a number of employees, one unhappy staff member decided that the best way to retaliate was to leak details of the bank’s credit scoring system to the press. See V. Orvice, “Would You Get a Loan?” Daily Mail, March 16, 1994, p. 29. 32.4 THE CREDIT DECISION Let us suppose that you have taken the first three steps toward an effective credit operation. In other words, you have fixed your terms of sale; you have decided on the contract that customers must sign, and you have established a procedure for estimating the probability that they will pay up. Your next step is to work out which of your customers should be offered credit. If there is no possibility of repeat orders, the decision is relatively simple. Figure 32.2 summarizes your choice. On one hand, you can refuse credit. In this case you make neither a profit nor a loss. The alternative is to offer credit. Sup- pose that the probability that the customer will pay up is p. If the customer does pay, you receive additional revenues (REV) and you incur additional costs; your Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 net gain is the present value of . Unfortunately, you can’t be certain that the customer will pay; there is a probability of default. Default means you receive nothing and incur the additional costs. The expected profit from each course of action is therefore as follows: 11 Ϫ p2 REV Ϫ COST CHAPTER 32 Credit Management 915 0 –COST Refuse credit Offer credit Customer defaults (1 – p ) Customer pays ( p ) REV–COST FIGURE 32.2 If you refuse credit, you make neither profit nor loss. If you offer credit, there is a probability p that the customer will pay and you will make REV Ϫ COST; there is a probability (1 Ϫ p) that the customer will default and you will lose COST. Expected Profit Refuse credit 0 Grant credit pPV(REV Ϫ COST) Ϫ (1 Ϫ p)PV(COST) You should grant credit if the expected profit from doing so is greater than the expected profit from refusing. Consider, for example, the case of the Cast Iron Company. On each nondelin- quent sale Cast Iron receives revenues with a present value of $1,200 and incurs costs with a value of $1,000. Therefore the company’s expected profit if it offers credit is If the probability of collection is 5/6, Cast Iron can expect to break even: Therefore Cast Iron’s policy should be to grant credit whenever the chances of collection are better than 5 out of 6. When to Stop Looking for Clues We told you earlier where to start looking for clues about a customer’s creditworthiness, but we never said anything about when to stop. Now we can work out how your profits would be affected by more detailed credit analysis. Suppose that Cast Iron Company’s credit department undertakes a study to determine which customers are most likely to default. It appears that 95 percent of its customers have been prompt payers and 5 percent have been slow payers. However, Expected profit ϭ 5 6 ϫ 200 Ϫ a1 Ϫ 5 6 b ϫ 1, 000 ϭ 0 pPV1REV Ϫ COST2 Ϫ 11 Ϫ p2PV1COST2 ϭ p ϫ 200 Ϫ 11 Ϫ p2 ϫ 1,000 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 customers with a record of slow payment are much more likely to default on the next order than those with a record of prompt payment. On the average 20 percent of the slow payers subsequently default, but only 2 percent of the prompt payers do so. Suppose Cast Iron reviews a sample of 1,000 customers, none of whom has defaulted yet. Of these, 950 have a record of prompt payment, and 50 have a record of slow payment. On the basis of past experience Cast Iron should expect 19 of the prompt payers to default in the future and 10 of the slow payers to do so: 916 PART IX Financial Planning and Short-Term Management Number of Probability of Expected Number Category Customers Default of Defaults Prompt payers 950 .02 19 Slow payers 50 .20 10 All customers 1,000 .029 29 Now the credit manager must make a decision: Should the company refuse to give any more credit to customers that have been slow payers in the past? If you are aware that a customer has been a slow payer, the answer is clearly yes. Every sale to a slow payer has only an 80 percent chance of payment . Sell- ing to a slow payer, therefore, gives an expected loss of $40: But suppose that it costs $10 to search through Cast Iron’s records to determine whether a customer has been a prompt or slow payer. Is it worth doing so? The expected payoff to such a check is In this case checking isn’t worth it. You are paying $10 to avoid a $40 loss 5 percent of the time. But suppose that a customer orders 10 units at once. Then checking is worthwhile because you are paying $10 to avoid a $400 loss 5 percent of the time: The credit manager therefore decides to check customers’ past payment records only on orders of more than five units. You can verify that a credit check on a five- unit order just pays for itself. Our illustration is simplistic, but you have probably grasped the message: You don’t want to subject each order to the same credit analysis. You want to concen- trate your efforts on the large and doubtful orders. Credit Decisions with Repeat Orders So far we have ignored the possibility of repeat orders. But one of the reasons for offering credit today is that you may get yourself a good, regular customer by doing so. Figure 32.3 illustrates the problem. 13 Cast Iron has been asked to extend credit to a new customer. You can find little information on the firm, and you believe that Expected payoff to credit check ϭ 1.05 ϫ 4002 Ϫ 10 ϭ $10 ϭ 1.05 ϫ 402 Ϫ 10 ϭϪ$8 Expected payoff to credit check ϭ probability of identifying a slow payer ϫ gain from not extending credit Ϫ cost of credit check ϭ.812002 Ϫ .211,0002 ϭϪ$40 Expected profit ϭ pPV1REV Ϫ COST2 Ϫ 11 Ϫ p2PV1COST2 1p ϭ .82 ( ) 13 Our example is adapted from H. Bierman, Jr., and W. H. Hausman, “The Credit Granting Decision,” Management Science 16 (April 1970), pp. B519–B532. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 the probability of payment is no better than .8. If you grant credit, the expected profit on this customer’s order is You decide to refuse credit. This is the correct decision if there is no chance of a repeat order. But look again at the decision tree in Figure 32.3. If the customer does pay up, there will be a re- order next year. Because the customer has paid once, you can be 95 percent sure that he or she will pay again. For this reason any repeat order is very profitable. Now you can reexamine today’s credit decision. If you grant credit today, you receive the expected profit on the initial order plus the possible opportunity to extend credit next year: ϭ Ϫ40 ϩ .80 ϫ PV11402 ϫ PV1next year’s expected profit on repeat order2 ϩ probability of payment and repeat order Total expected profit ϭ expected profit on initial order ϭ 1.95 ϫ 2002 Ϫ 1.05 ϫ 1, 0002ϭ $140 PV1 COST 2 2 Next year’s expected profit on repeat order ϭ p 2 PV1REV 2 Ϫ COST 2 2 Ϫ 11 Ϫ p 2 2 ϭ 1 .8 ϫ 2002 Ϫ 1.2 ϫ 1,0002 ϭϪ$40 Ϫ 11 Ϫ p 1 2 ϫ PV1COST2 Expected profit on initial order ϭ p 1 ϫ PV1REV Ϫ COST2 CHAPTER 32 Credit Management 917 Period 1 Period 2 0 –COST 1 Refuse credit Refuse credit Offer credit Offer credit Customer pays p 2 = .95 Customer defaults (1 - p 2 ) = .05 Customer defaults (1 – p 1 ) = .2 Customer pays p 1 = .8 0 –COST 2 REV 1 – COST 1 REV 2 –COST 2 FIGURE 32.3 In this example there is only a .8 probability that your customer will pay in period 1; but if payment is made, there will be another order in period 2. The probability that the customer will pay for the second order is .95. The possibility of this good repeat order more than compensates for the expected loss in period 1. [...]... which the buyer actually QUIZ 921 Visit us at www.mhhe.com/bm7e Brealey−Meyers: Principles of Corporate Finance, Seventh Edition Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 922 PART IX IX Financial Planning and Short−Term Management 32 Credit Management © The McGraw−Hill Companies, 2003 Financial Planning and Short-Term Management pays is the due lag, and the lag between the purchase... financial statements (figures in millions) Visit us at www.mhhe.com/bm7e Brealey−Meyers: Principles of Corporate Finance, Seventh Edition Brealey−Meyers: Principles of Corporate Finance, Seventh Edition PART NINE RELATED WEBSITES IX Financial Planning and Short−Term Management © The McGraw−Hill Companies, 2003 32 Credit Management For an introductory guide to understanding financial statements see:... percent of sales, and fixed costs are a further 5 percent of sales Velcro classifies customers on a scale of 1 to 4 During the past five years, the collection experience was as follows: Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 924 IX Financial Planning and Short−Term Management 32 Credit Management © The McGraw−Hill Companies, 2003 PART IX Financial Planning and Short-Term Management... stake in the continued prosperity of the firm For some evidence on the determinants of the supply and demand for trade credit, see M A Petersen and R G Rajan, “Trade Credit: Theories and Evidence,” Review of Financial Studies 10 (1997), pp 661–692 919 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 920 IX Financial Planning and Short−Term Management 32 Credit Management © The McGraw−Hill... businesses This is part of the cost of building up a good customer list 32. 5 COLLECTION POLICY It would be nice if all customers paid their bills by the due date But they don’t— and since you may also occasionally “stretch” your payables, you can’t altogether blame them Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX Financial Planning and Short−Term Management 32 Credit Management... letter of credit The third step is to assess each customer’s creditworthiness There are a variety of sources of information—your own experience with the customer, the experience of other creditors, the assessment of a credit agency, a check with the customer’s bank, the market value of the customer’s securities, and an analysis of the customer’s fi- IX Financial Planning and Short−Term Management 32 Credit.. .Brealey−Meyers: Principles of Corporate Finance, Seventh Edition 918 IX Financial Planning and Short−Term Management 32 Credit Management © The McGraw−Hill Companies, 2003 PART IX Financial Planning and Short-Term Management At any reasonable discount rate, you ought to extend credit For example, if the discount rate is 20 percent, Total expected profit 1present value 2 ϭ Ϫ40... discussion in Section 32. 4 of credit decisions with repeat orders If p1 ϭ 8, what is the minimum level of p2 at which Cast Iron is justified in extending credit? 7 True or False? a Exporters who require greater certainty of payment arrange for the customers to sign a bill of lading in exchange for a sight draft b Multiple-discriminant analysis is often used to construct an index of creditworthiness This... Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX Financial Planning and Short−Term Management © The McGraw−Hill Companies, 2003 32 Credit Management CHAPTER 32 Credit Management 923 2 Some of the items in question 1 involve a cash discount For each of these, calculate the rate of interest paid by customers who pay on the due date instead of taking the cash discount 3 Phoenix Lambert currently... sources and costs of short-term finance) www.ny.frb.org/pihome/addpub/credit pdf (a guide to sources of credit) www.prars.com The websites of most major banks provide material on cash management services See, for example: Downloadable software for short- and longterm financial planning is available on: www.bankone.com www.decisioneering.com www.bankofamerica.com Journals with articles on short-term financial . Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit Management © The McGraw−Hill Companies, 2003 CHAPTER THIRTY-TWO 908 C. Smith, “Ev- idence on the Determinants of Credit Terms Used in Interfirm Trade,” Journal of Finance 54 (June 1999), pp. 1109–1129. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX an analysis of the customer’s fi- Visit us at www.mhhe.com/bm7e Brealey−Meyers: Principles of Corporate Finance, Seventh Edition IX. Financial Planning and Short−Term Management 32. Credit

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