Fundamentals of corproate finance 3e chapter 14

Chapter Fourteen Credit Management Copyright  2004 McGraw-Hill Australia Pty Ltd 14-1 Chapter Organisation 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-2 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-3 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-4 Cash Flows from Granting Credit Credit sale is made Customer mails cheque Firm deposits cheque in bank Bank credits firm’s account Time Cash collection Accounts receivable Copyright  2004 McGraw-Hill Australia Pty Ltd 14-5 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-6 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-7 Cost of the Credit • • 2/10, net 30 = buyer pays in 10 days to get a 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 30   EAR = 1 +   470  • 365 20 − = 44.59% The benefit obviously lies in paying early Copyright  2004 McGraw-Hill Australia Pty Ltd 14-8 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-9 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: New cash flow − old cash flow [ ( P − v ) × Q' ] − [ ( P − v ) × Q] rearranging ( P − v ) × ( Q' − Q ) Copyright  2004 McGraw-Hill Australia Pty Ltd 14-10 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-11 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% Copyright  2004 McGraw-Hill Australia Pty Ltd 14-12 Solution—Evaluating a Proposed Credit Policy Cash flow (old policy) = ( P − v ) × Q = ( 55 − 32 ) × 160 = $3680 Cash flow (new policy) = ( P − v ) × Q' = ( 55 − 32 ) × 175 = $4025 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-13 Solution—Evaluating a Proposed Credit Policy Benefit of switching = ( P − v ) ( Q' − Q ) = ( 55 − 32) (175 − 160 ) = $345 ( [ P − v ) × ( Q' − Q ) ] PV of switching = R 345 = 0.02 = $17 250 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-14 Solution—Evaluating a Proposed Credit Policy Cost of switching = PQ + v ( Q' − Q ) = ( 55 × 160 ) + 32 (175 − 160 ) = $8320 NPV of switching = − [ PQ + v ( Q' − Q ) ] + ( P − v ) ( Q' − Q ) /R = − 8320 + 17 250 = $8930 Therefore, the switch is very profitable Copyright  2004 McGraw-Hill Australia Pty Ltd 14-15 Break-even Point ( PQ ) Q' − Q = [ ( P − v ) /R − v] ( 55 × 160 ) = [ ( 55 − 32) / 0.02 − 32] = 7.87 units The switch is a good idea as long as the company can sell an additional 7.87 units Copyright  2004 McGraw-Hill Australia Pty Ltd 14-16 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? Percentage discount allowed for cash customers ( d ) ( $56 − $55) = 1.79% = $56 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-17 Discounts and Default Risk NPV of changing credit terms: NPV = − PQ + P' Q × ( d − π) /R = − $55 × 160 + $56 × 160 × ( 0.0179 − 0.005) / 0.02 = − $3020.80 As the NPV of the change is negative, ABC Co should not switch Copyright  2004 McGraw-Hill Australia Pty Ltd 14-18 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-19 Optimal Credit Policy Copyright  2004 McGraw-Hill Australia Pty Ltd 14-20 Credit Analysis • Process of deciding which customers receive credit • One-time sale—risk is variable cost only • Repeat customers—benefit is gained from onetime sale in perpetuity • Grant credit to almost all customers once as long as variable cost is low relative to price (high markup) Copyright  2004 McGraw-Hill Australia Pty Ltd 14-21 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-22 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 Copyright  2004 McGraw-Hill Australia Pty Ltd 14-23 .. .Chapter Organisation 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... Analysis 14. 7 Collection Policy 14. 8 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd 14- 2 Chapter Objectives • • • • • • • Understand the components of credit policy and the cash... the optimal credit policy Discuss the five Cs of credit Copyright  2004 McGraw-Hill Australia Pty Ltd 14- 3 Components of Credit Policy • Terms of sale The conditions on which a firm sells its