28-1 CHAPTER 28 Credit Management McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-2 Chapter Outline 28.1 Terms of the Sale 28.2 The Decision to Grant Credit: Risk and Information 28.3 Optimal Credit Policy 28.4 Credit Analysis 28.5 Collection Policy 28.6 How to Finance Trade Credit 28.7 Summary & Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-3 Introduction A firm’s credit policy is composed of: Terms of the sale Credit analysis Collection policy This chapter discusses each of the components of credit policy that makes up the decision to grant credit McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-4 The Cash Flows of Granting Credit Credit sale is made Customer mails check Firm deposits check Bank credits firm’s account Time Cash collection Accounts receivable McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-5 28.1 Terms of the Sale The terms of sale of composed of Credit Period Cash Discounts Credit Instruments McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-6 Credit Period Credit periods vary across industries Generally a firm must consider three factors in setting a credit period: The probability that the customer will not pay The size of the account The extent to which goods are perishable Lengthening the credit period generally increases sales McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-7 Cash Discounts Often part of the terms of sale Tradeoff between the size of the discount and the increased speed and rate of collection of receivables An example would be “3/10 net 30” The customer can take a 3% discount if he pays within 10 days In any event, he must pay within 30 days McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-8 The Interest Rate Implicit in 3/10 net 30 A firm offering credit terms of 3/10 net 30 is essentially offering their customers a 20-day loan To see this, consider a firm that makes a $1,000 sale on day Some customers will pay on day 10 and take the discount $970 10 30 Other customers will pay on day 30 and forgo the discount $1,000 McGraw-Hill/Irwin Corporate Finance, 7/e 10 30 © 2005 The McGraw-Hill Companies, Inc All Rights 28-9 The Interest Rate Implicit in 3/10 net 30 A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest: –$1,000 +$970 10 30 $1,000 = $970 (1 + r )20 365 (1 + r ) 20 365 365 20 $1,000 r= $970 McGraw-Hill/Irwin Corporate Finance, 7/e $1,000 = $970 −1 = 7435 = 74.35% © 2005 The McGraw-Hill Companies, Inc All Rights 2810 Credit Instruments Most credit is offered on open account—the invoice is the only credit instrument Promissory notes are IOUs that are signed after the delivery of goods Commercial drafts call for a customer to pay a specific amount by a specific date The draft is sent to the customer’s bank, when the customer signs the draft, the goods are sent Banker’s acceptances allow a bank to substitute its creditworthiness for the customer, for a fee Conditional sales contracts let the seller retain legal ownership of the goods until the customer has completed payment McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2816 Example of the Decision to Grant Credit How high must the credit price be to make it worthwhile for the firm to extend credit? The NPV of Net 30 must be at least as big as the NPV of cash only: 1,300 × P0 × 0.95 $100,000 = −1,300 × $425 + 30 / 365 (1.10) ' 30 / 365 ' + × × = × ($100,000 1,300 $425) (1.10) 1,300 P0 × 0.95 30 / 365 + × × ($ 100 , 000 , 300 $ 425 ) ( 10 ) = $532.50 P0' = 1,300 × 0.95 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2817 The Value of New Information about Credit Risk The most that we should be willing to pay for new information about credit risk is the present value of the expected cost of $0 defaults: NPV default = –C0′ × Q0′ × (1 – h) + NPV default = –C0′ × Q0′ × (1 – h) (1 + rB) In our earlier example, with a credit price of $500, we would be willing to pay $27,625 for a perfect credit screen C0′ × Q0′ × (1 – h) = $425×1,300×(1 – 0.95) = $27,625 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2818 Future Sales and the Credit Decision We face a more certain credit decision with our paying customers: Information is revealed at the end of the first period: Give credit Customer pays (Probability = h) Give credit Our first decision: Do not give credit Customer defaults (Probability = 1– h) Do not give credit McGraw-Hill/Irwin Corporate Finance, 7/e Customer pays h = 100% We refuse further sales to deadbeats © 2005 The McGraw-Hill Companies, Inc All Rights 2819 28.3 Optimal Credit Policy Costs in dollars Total costs Carrying Costs Opportunity costs C* Level of credit extended At the optimal amount of credit, the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2820 28.3 Optimal Credit Policy Trade Credit is more likely to be granted if: The selling firm has a cost advantage over other lenders The selling firm can engage in price discrimination The selling firm can obtain favorable tax treatment The selling firm has no established reputation for quality products or services The selling firm perceives a long-term strategic relationship The optimal credit policy depends on the characteristics of particular firms McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2821 28.4 Credit Analysis Credit Information Financial Statements Credit Reports on Customer’s Payment History with Other Firms Banks Customer’s Payment History with the Firm McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2822 28.4 Credit Analysis Credit Scoring: The traditional C’s of credit Character Capacity Capital Collateral Conditions Some firms employ sophisticated statistical models McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2823 28.5 Collection Policy Collection refers to obtaining payment on past-due accounts Collection Policy is composed of The firm’s willingness to extend credit as reflected in the firm’s investment in receivables Collection Effort McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2824 Average Collection Period Measures the average amount of time required to collect an account receivable Average Collection Period = Accounts receivable Average daily sales For example, a firm with average daily sales of $20,000 and an investment in accounts receivable of $150,000 has an average collection period of $150,000 7.5 days = $20,000/day McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2825 Accounts Receivable Aging Schedule Shows receivables by age of account The longer an account has been unpaid, the less likely it is to be paid McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2826 Collection Effort Most firms follow a protocol for customers that are past due: Send a delinquency letter Make a telephone call to the customer Employ a collection agency Take legal action against the customer McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2827 Collection Effort There is a potential for a conflict of interest between the collections department and the sales department You need to strike a balance between antagonizing a customer and being taken advantage of by a deadbeat McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2828 Factoring The sale of a firm’s accounts receivable to a financial institution (known as a factor) The firm and the factor agree on the basic credit terms for each customer The factor pays an agreedCustomers send payment to the factor Customer McGraw-Hill/Irwin Corporate Finance, 7/e Factor Goods upon percentage of the accounts receivable to the firm The factor bears the risk of nonpaying customers Firm © 2005 The McGraw-Hill Companies, Inc All Rights 2829 28.6 How to Finance Trade Credit There are three general ways of financing accounting receivables: Secured Debt – Referred to as asset-based receivables financing – The predominant form of receivables financing Captive Finance Company – Large companies with good credit ratings often form a finance company as a subsidiary of the firm Securitization – Occurs when the selling firm sells its accounts receivable to a financial institution, which then pools the receivables and sells securities backed by these assets McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 2830 28.7 Summary & Conclusions The components of a firm’s credit policy are the terms of sale, the credit analysis, and the collection policy The decision to grant credit is a straightforward NPV problem Additional information about the probability of customer default has value, but must be weighed against the cost of the information The optimal amount of credit is a function of the conditions in which a firm finds itself The collection policy is the firm’s method for dealing with past-due accounts—it is an integral part of the decision to extend credit McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... Policy 28.4 Credit Analysis 28.5 Collection Policy 28.6 How to Finance Trade Credit 28.7 Summary & Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights... Discounts Credit Instruments McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-6 Credit Period Credit periods vary across industries Generally a firm must consider... check Bank credits firm’s account Time Cash collection Accounts receivable McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 28-5 28.1 Terms of the Sale The