Principles of Corporate Finance Brealey and Myers Sixth Edition Credit Management Slides by Matthew Will Irwin/McGraw Hill Chapter 30 ©The McGraw-Hill Companies, Inc., 200 30- Topics Covered Terms of Sale Commercial Credit Instruments Credit Analysis The Credit Decision Collection Policy Bankruptcy Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- Terms of Sale Terms of Sale - Credit, discount, and payment terms offered on a sale Example - 5/10 net 30 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- Terms of Sale A firm that buys on credit is in effect borrowing from its supplier It saves cash today but will have to pay later This, of course, is an implicit loan from the supplier We can calculate the implicit cost of this loan Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- Terms of Sale A firm that buys on credit is in effect borrowing from its supplier It saves cash today but will have to pay later This, of course, is an implicit loan from the supplier We can calculate the implicit cost of this loan Effective annual rate ( = + Irwin/McGraw Hill ) discount discounted price 365 / extra days credit - ©The McGraw-Hill Companies, Inc., 200 30- Terms of Sale Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- Terms of Sale Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? Effective annual rate 1+ 365/extra days credit discount discounted price 1 + 365/50 95 Irwin/McGraw Hill -1 - = 454, or 45.4% ©The McGraw-Hill Companies, Inc., 200 30- Credit Instruments Terminology open account promissory note commercial draft sight draft time draft trade acceptance banker’s acceptance Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- Credit Analysis Credit Analysis - Procedure to determine the likelihood a customer will pay its bills Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer Financial ratios can be calculated to help determine a customer’s ability to pay its bills Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 10 Credit Analysis Numerical Credit Scoring categories The customer’s character The customer’s capacity to pay The customer’s capital The collateral provided by the customer The condition of the customer’s business Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 11 Credit Analysis Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 12 Credit Analysis Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time Altman Z Score formula Z = 3.3 EBIT sales market value of equity + 1.0 +.6 total assets total assets total book debt + 1.4 Irwin/McGraw Hill retained earnings working capital + 1.2 total assets total assets ©The McGraw-Hill Companies, Inc., 200 30- 13 Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 14 Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? EBIT = total assets retained earnings = total assets sales = total assets working capital = 12 total assets market equity = book debt Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 15 Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2.7 or higher, would we accept the following client? Firm' s Z Score ( 3x 12) +(1 0x1 4) +( 6x 9) +(1 x 4) +(1 x 12) = 04 A score above 2.7 indicates good credit Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 16 Credit Analysis Credit analysis is only worth while if the expected savings exceed the cost Don’t undertake a full credit analysis unless the order is big enough to justify it Undertake a full credit analysis for the doubtful orders only Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 17 The Credit Decision Credit Policy - Standards set to determine the amount and nature of credit to extend to customers Extending credit gives you the probability of making a profit, not the guarantee There is still a chance of default Denying credit guarantees neither profit or loss Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 18 The Credit Decision The credit decision and its probable payoffs Offer credit Refuse credit Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 19 The Credit Decision The credit decision and its probable payoffs Customer pays = p Offer credit Customer defaults = 1-p Refuse credit Payoff = Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 20 The Credit Decision The credit decision and its probable payoffs Payoff = Rev - Cost Customer pays = p Offer credit Customer defaults = 1-p Payoff = - Cost Refuse credit Payoff = Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 21 The Credit Decision Based on the probability of payoffs, the expected profit can be expressed as: Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 22 The Credit Decision Based on the probability of payoffs, the expected profit can be expressed as: p x PV(Rev - Cost) - (1 - p) x (PV(cost) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 23 The Credit Decision Based on the probability of payoffs, the expected profit can be expressed as: p x PV(Rev - Cost) - (1 - p) x (PV(cost) The break even probability of collection is: PV(Cost) p = PV(Rev) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 24 Collection Policy Collection Policy - Procedures to collect and monitor receivables Aging Schedule - Classification of accounts receivable by time outstanding Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 25 Collection Policy Sample aging schedule for accounts receivable Customer' s Amount Not Month More than Name Yet Due Overdue Month Overdue Alpha 10,000 0 Total Owed 10,000 Beta 0 5,000 5,000 * * * * * * * * * * * Omega * 5,000 * 4,000 * 21,000 * 30,000 Total $200,000 $40,000 Irwin/McGraw Hill $58,000 $298,000 ©The McGraw-Hill Companies, Inc., 200 ... Companies, Inc., 200 30- Terms of Sale Terms of Sale - Credit, discount, and payment terms offered on a sale Example - 5/10 net 30 - percent discount for early payment 10 - number of days that the... Inc., 200 30- 20 The Credit Decision The credit decision and its probable payoffs Payoff = Rev - Cost Customer pays = p Offer credit Customer defaults = 1-p Payoff = - Cost Refuse credit Payoff =... of default Denying credit guarantees neither profit or loss Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 30- 18 The Credit Decision The credit decision and its probable payoffs Offer