SOME EXAMPLES OF CREDIT POLICY Credit standard: The relaxation of credit standards changes ACP of only new customers Problem A firm’s product sells for $10 a unit, of which 8$ represents variable costs before taxes, including credit department costs The firm is operating at less than full capacity, and an increase in sales can be accommodated without any increase in fixed costs Currently, annual credit sales are running at a level of $2.4 million, and there is no underlying growth trend in such credit sales The relaxation in credit standards is expected to produce at 25% increase in annual sales Existing customers are not expected to alter their payment habits (continue to pay in month), but the more liberal credit results in increased average collection period of months for new customers And the firm’s opportunity cost of carrying the additional receivables is 20% before taxes Should the firm liberalize credit? Solution The contribution margin per unit (price – variable cost) $10 - $8 = $2 New sales = Old sales x (1+25%) 2,4x1,25 = $3 million Additional sales $600,000 Additional units sold 600,000/10 = 60,000 units Profitability of additional sales = contribution margin per unit x x 60,000 = $120,000 Additional units sold Receivable turnover for new customers 12/2 = Additional average receivables = Additional sales / Receivable 600,000 / = $100,000 turnover Investment in additional receivables = (Variable cost / sales) x 100,000 x 8/10 = $80,000 additional receivables Required before-tax return on additional investment = $80,000 x 20% = $16,000 Investment in additional receivables x opportunity cost Compare profitability with required before-tax return on additional investment => Should adopt Credit period: The change of ACP for both existing and new customers Problem For example (with data as problem 1), the firm’s credit terms might be expressed as “…net 30” It wants to change credit terms from “net 30” to “net 60” The more liberal credit period results in increased sales of $360,000, and these new customers also pay, on average, in months The average collection period for existing customers goes from month to months Should the firm change credit period? Solution Profitability of additional sales = contribution margin x additional units sold Receivable turnover for existing customers $2 x 36,000 = $72,000 Receivable turnover for new customers 12/2 = times Additional average receivables = Additional sales / New Receivable turnover Investment in additional receivables = (Variable cost / sales) x additional receivables Average receivables before credit period change = old sales/old receivable turnover Average receivables associated with original sales $360,000 / = $60,000 Investment in additional receivables associated with original sales 400,000 Total investment in additional receivables 12/1 = 12 times 60,000 x 8/10 = $48,000 $2,4million/12 = $200,000 $2,4 million / = $400,000 – 200,000 = $200,000 $48,000 + $200,000 = $248,000 Required before-tax return on additional investment = $248,000 x 20% = $49,600 Discount Problem The firm has annual credit sales of $3 million and an average collection period of months Also, assume that sales terms are “net 45” with no cash discount given By initiating terms of “2/10 net 45”, the average collection period can be reduced to month, as 60% of the customers (in dollar volume) take advantage of the 2% discount We assume a 20% before-tax rate of return, should the firm adopt a 2% discount? Solution Old Receivable turnover = 12/2 = times Old average receivables = $3 million / = $500,000 New receivable turnover = 12/1 = 12 times New average receivables = $3 million/12 = $250,000 Reduction of investment in receivables = $500,000 - $250,000 = $250,000 The opportunity savings = 20% x $250,000 = $50,000 The opportunity cost of the discount = 2% x 60% x $3 million = $36,000 => Compare the opportunity savings and the cost of the discount => The firm should adopt a 2% discount Problem 4: Default Risk Annual receivable turnover Contribution margin is 20% 12 Solution Policy A Policy B Additional sales $600,000 $300,000 Profitability of additional sales = (20% contribution margin) x (Additional sales) 120,000 60,000 Additional bad-debt losses = (Additional sales) x (Bad-debt percentage) 60,000 54,000 Additional receivables = Additional sales/New receivable turnover 100,000 75,000 Investment in additional receivables = 0.8 x (Additional receivables) 80,000 60,000 Required before-tax return on additional investment (20%) 16,000 12,000 Additional bad-debt losses plus additional required return = (3) – (6) 76,000 66,000 Incremental profitability = (2) – (7) 44,000 (6,000) ... Credit period: The change of ACP for both existing and new customers Problem For example (with data as problem 1), the firm’s credit terms might be expressed as “…net 30” It wants to change credit. . .Credit standard: The relaxation of credit standards changes ACP of only new customers Problem A firm’s product sells for $10 a unit, of which 8$ represents variable costs before taxes,... the more liberal credit results in increased average collection period of months for new customers And the firm’s opportunity cost of carrying the additional receivables is 20% before taxes Should