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ORGANIZATION Powered By Docstoc
					CHAPTER 20


S20.1: Key Concepts and Skills
S20.2: Chapter Outline
S20.3: Credit Management: Key Issues
S20.4: Components of Credit Policy
S20.5: The Cash Flows from Granting Credit
S20.6: Terms of Sale
S20.7: Example: Cash Discounts
S20.8: Credit Policy Effects
S20.9: Example: Evaluating a Proposed Policy – Parts I and II (2 pages)
S20.11: Total Cost of Granting Credit
S20.12: The Costs of Granting Credit
S20.13: Credit Analysis
S20.14: Example: One Time Sale
S20.15: Example: Repeat Customers
S20.16: Credit Information
S20.17: Five Cs of Credit
S20.18: Collection Policy
S20.19: Inventory Management (4 pages)
S20.23: Economic Order Quantity (EOQ) Model, Example and Extensions (3 pages)
S20.26: More on Credit Policy Analysis – Appendix 20A
S20.27: Quick Quiz
S20.28: Summary

  S20.1: Key Concepts and Skills

  S20.2: Chapter Outline

          Components of Credit Policy
          The Cash Flows from Granting Credit
          The Investment in Receivables
          The Basic Form
          The Credit Period

          Cash Discounts
          Credit Instruments
          Credit Policy Effects
          Evaluating a Proposed Credit Policy
          The Total Credit Cost Curve
          Organizing the Credit Function
          When Should Credit Be Granted?
          Credit Information
          Credit Evaluation and Scoring
          Monitoring Receivables
          Collection Effort
          The Financial Manager and Inventory Policy
          Inventory Types
          Inventory Costs
          The ABC Approach
          The Economic Order Quantity Model
          Extensions to the EOQ Model
          Managing Derived-Demand Inventories

          Two Alternative Approaches
          Discounts and Default Risk


  S20.3: Credit Management: Key Issues

              When credit is granted to other firms, it's called trade credit. When granted to
              consumers, it's called consumer credit.

       A. Components of Credit Policy

  S20.4: Components of Credit Policy

              1. Terms of sale—credit period, discounts and discount period, credit instrument
              2. Credit analysis—who gets credit (and how much), and who doesn't
              3. Collection policy—how to get borrowers to pay

       B. The Cash Flows from Granting Credit

  S20.5: The Cash Flows from Granting Credit

       C. The Investment in Receivables
              The investment in receivables depends upon the average collection period and the level
              of average daily credit sales.

              Accounts receivable = Average daily sales × average collection period

                   Some students might question why the amount of investment in accounts receivable
              is the daily sales times ACP, since "sales" contains cost plus profit, and the out-of-pocket
              investment required would be the cost of the receivables, excluding the profit reflected in
              the receivables balance. Point out that the analysis refers to the funds committed to this
              balance. If the receivables balance could be reduced by 10 days, these 10 days'
              receivables would be immediately freed up. Thus, the investment in receivables should
              be viewed in terms of the funds which are tied up for the company.


              1. The credit period
              2. Cash discounts and discount period
              3. The credit instrument

  S20.6: Terms of Sale

A. The Basic Form
      a/b, net c—e.g., 1/10, net 30
      In other words, (take this discount off the invoice price)/(if you pay in this many days),
      (else pay the full invoice amount in this many days).

B. The Credit Period
      Credit period—the length of time before the borrower is supposed to pay.

      Two components: net credit period and cash discount period

      1. Invoice date—begins the credit period, usually the shipping or billing date.
          ROG—receipt of goods
          EOM—end-of-month (Invoice date is the end of the month for all sales.)
          Seasonal dating—invoice date corresponds to "season" of goods

      2. Length of the credit period depends upon:
          -Buyer’s inventory and operating cycle
          -Perishability and collateral value
          -Consumer demand
          -Cost, profitability and standardization
          -Credit risk
          -The size of the account
          -Customer type

C. Cash Discounts
      1. Cost of credit—the cost of not taking discounts offered

      periodic rate = (discount %)/(100 – discount %)
      APR = periodic rate × 365/(net period – discount period)
      EAR = (1 + periodic rate/100)365/(net period – discount period) – 1

      Example: Cost of Foregone Discounts

      On terms of 1/15, net 45 the cost of foregone discounts (given payment in 45 days) is:
          periodic rate = 1/(100 – 1) = 1.01%

                   APR = 1.01% × 365/(45 – 15) = 1.01% × 12.167 = 12.29%
                   EAR = (1 + .0101)12.167 – 1 = 1.130 – 1 = .130 or 13%

               2. Trade discounts—unlike true discounts, these are not an inducement to early payment,
               but are the regular terms.

               3. The cash discount and the ACP—offering discounts generally reduces the ACP as
               customers pay sooner. Whether or not receivables are also reduced depends upon the
               effect of the discount on the amount of credit sales as well as the ACP.

                   You may want to stress that when a company does not take advantage of discount
               terms such as sales terms of 2/10, net 30, the company is effectively borrowing the
               invoice cost for 20 days at a 2 percent cost. Some students might suspect that since the
               company does not have to pay its bill for 30 days, the company secures the use of the
               funds for 30 days. Emphasize that it is the marginal time period for funds usage, not the
               total time period allowed before payment, that is relevant in determining the effective
               annual rate. Although this is heavily emphasized in the Cost of the Credit section, an
               added classroom comment is typically helpful.

  S20.7: Example: Cash Discounts

       D. Credit Instruments—the evidence of indebtedness
               Open account—transaction evidenced by invoice and recorded on the books.
               Promissory note—an IOU used when some trouble in collecting is expected.
               Commercial draft—sight draft (due on presentation), time draft (due at some date), trade
               acceptance (buyer "accepts" draft, i.e., promises to pay later), banker's acceptance (bank
               accepts draft, i.e., promises to pay later).

                   Various instruments have been developed to shift the risk of nonpayment of
               receivables in international transactions from the seller to a financial institution. In this
               context, the banker's acceptance described above is actually an irrevocable letter of
               credit issued by a bank guaranteeing payment of the face amount. A letter of credit, in
               turn, is simply a promise from the buyer's bank to make payment upon receipt of the
               goods by the buyer. The instructor should point out that, while these guarantee
               arrangements add to the cost of doing business, their existence greatly facilitates
               international trade.

       A. Credit Policy Effects

  S20.8: Credit Policy Effects

             1. Revenue effects—price and quantity sold may be increased.
             2. Cost effects—the cost of running a credit scheme and collecting receivables.
             3. The cost of debt—firm must finance receivables.
             4. The probability of nonpayment—always get paid if you sell for cash.
             5. The cash discount—affects payment patterns and amounts.

     B. Evaluating a Proposed Credit Policy

S20.9: Evaluating a Proposed Policy – Parts I and II (2 pages)

                 P     = price per unit
                 V     = variable cost per unit
                 Q     = current quantity sold per period
                 Q     = new quantity expected to be sold
                 R     = periodic required return (corresponds to the ACP)

             The benefit of switching is change in cash flow, i.e., (new cash flow old cash flow):

                         (P – v) × Q  – (P – v) × Q = (P – v) × ( Q  – Q )

             Periodic benefit is the gross profit × change in quantity. The PV of switching is:

                                    PV = [(P – v)( Q  – Q )]/R.

             The cost of switching is the amount uncollected for the period + the additional variable
             costs of production:

                                     Cost = P Q + v( Q  – Q )

             Finally, the NPV of the switch is:

                   NPV = – [P Q + v( Q  – Q ))] + (P – v) ( Q  – Q )/R

             1. A break-even application—what change in quantity would produce a $0 NPV?

                    Q  – Q = (P Q )/[(P – v)/R – v]

                  It's useful to point out that the process for determining the NPV of a credit policy
              switch is no different from the process for determining the NPV of a capital asset
              replacement (or "switch"). The analysis involves a comparison of the marginal costs
              with the marginal benefits to be realized from the switch. If a company liberalizes credit
              terms, the present value of the marginal profit is compared to the immediate investment
              in a higher receivables balance. If a company tightens credit, lower sales should be
              expected. The present value of the reduction in profit is compared to the cash realized
              from the lower amount invested in receivables.

              In principle, the optimal credit policy is one for which incremental cash flows from sales
              equal the incremental costs of carrying the increased investment in accounts receivable.

       A. The Total Credit Cost Curve

  S20.11: Total Cost of Granting Credit

              Credit policy represents the trade-off between two kinds of costs:

              Carrying costs:
              -the required return on receivables
              -the losses from bad debts
              -the costs of managing credit and collections

              Opportunity costs:
              -potential profit from credit sales lost

                  As noted in the text, separating the finance and non-finance lines of business by
              creating a captive finance subsidiary may lower the firm's overall cost of debt. Dennis E.
              Logue suggests that this is due, in part, to the fact that "different levels of assets can
              support varying degrees of leverage." Put another way, this suggests that the standards
              an analyst would apply to the financial statements of the parent should reflect the
              parent's main line(s) of business, while the standards applied to the statements of the
              subsidiary should reflect the fact that it is a finance company. (See Dennis E. Logue, The
              Handbook of Modern Finance, second edition, Warren, Gorham, and Lamont, 1990.)

  S20.12: The Costs of Granting Credit


  S20.13: Credit Analysis

       A. When Should Credit Be Granted?
              1. A One-Time Sale
                  Let  be the percentage of new customers who default
                  NPV = –v + (1 –  )P/(1 + R)
                  The firm risks –v to gain P a period later.

  S20.14: Example: One Time Sale

              2. Repeat Business
                  NPV = –v + (1–  )(P – v)/R

                  Try initiating this section with a discussion of the credit card offerings many banks
              provide for students. Note that the default risk may be higher among college students but
              the marginal benefit, at 18% to 21% interest charges on unpaid balances, justifies this
              decision for the bank. However, the bank controls this risk with lower credit limits for
              riskier customer classes and providing the student with a credit card while in college
              allows the bank to establish student loyalty to their card.
                  Interestingly, bank card offerings seemed to reach their zenith in 1996 as large
              issuers sought to increase market share in an increasingly competitive market. The
              method for doing so was, in large part, simply a lowering of credit standards to "flood
              the market with consumer credit" in the words of one financial commentator. The
              rationale was to increase market share in an increasingly competitive market.

  S20.15: Example: Repeat Customers

       B. Credit Information
             Some typical sources of credit information are:

              1. Financial statements
              2. Credit reports (i.e., Dun and Bradstreet report)
              3. Banks
              4. The customer's payment history

  S20.16: Credit Information

       C. Credit Evaluation and Scoring

  S20.17: Five Cs of Credit

              The five Cs of credit
              1. Character—willingness to pay
              2. Capacity—ability to pay out of cash flows
              3. Capital—financial reserves
              4. Collateral—pledged assets
              5. Conditions—economic conditions in customer's industry

                  You may wish to emphasize here that full-blown credit analysis contains both
              quantitative and qualitative aspects. As any loan officer will tell you, using the five Cs to
              evaluate a potential lender reflects both types of considerations. For example, capacity
              and capital are measured primarily by examination of the borrower's financial
              statements, while character is measured by both the borrower's prior credit history, as
              well as by the lender's (often highly unscientific) assessment of the borrower's integrity.
              Complicating the decision is that the most difficult C to assess, character, is often said to
              be the most important determinant of repayment. After all, if a borrower is unwilling to
              repay, what difference do the other characteristics make?

              Credit scoring—assigning a numerical rating to customer to indicate creditworthiness.

       A. Monitoring Receivables
              Aging schedule—a breakdown of receivables accounts by age.

                           Age of Account          Amount outstanding              % of receivables
                               0 - 30 days                   $ 67,550                      85.39%
                              31 - 60 days                     10,480                      13.25%
                             Over 60 days                       1,075                        1.36%
                  Wilbur Lewellen and Robert Johnson demonstrate that two of the traditional
              receivables monitoring tools - the number of days' sales outstanding and the aging
              schedule - are influenced by the pattern of sales and may be misinterpreted by managers
              who are unaware of this effect. Fortunately, eliminating this problem is straightforward
              - according to Lewellen and Johnson, one need only employ balances outstanding as a
              percentage of the respective original sales which generated them. Their solution is

              discussed in more detail in "Better Way to Monitor Accounts Receivable," Harvard
              Business Review, May-June 1972, pp. 101-109.

  S20.18: Collection Policy

       B. Collection Effort
              Usual procedures for overdue accounts:
              1. Send delinquency letter
              2. Call customer
              3. Employ collection agency
              4. Legal action

       A. The Financial Manager and Inventory Policy
              Although financial managers don't typically set inventory policy, they do provide input,
              and must be able to measure the benefits and costs associated with various policies.

 S20.19:   Inventory Management (4 pages)

       B. Inventory Types
              For a manufacturer, inventory is classified into one of three categories: raw materials,
              work-in-progress (W-I-P), and finished goods.

              Things to keep in mind:
                  1. Classification is a function of the nature of the firm's business.
                  2. Inventory types can be different in terms of their liquidity.
                  3. Demand for raw materials and W-I-P are based on demand for finished goods.
       C. Inventory Costs
              There are two basic types of costs associated with current assets in general and inventory
              in particular: carrying costs and shortage costs.

       A. The ABC Approach

       B. The Economic Order Quantity (EOQ) Model
                  The EOQ model assumes the firm's inventory is sold at a steady rate until it hits
              zero. Firms with seasonal demand would experience a more difficult problem
              determining the optimal inventory level to maintain. In the "Collection Policy" section,

           the text states "Firms with seasonal sales will find the percentages on the aging schedule
           changing during the year." Ask students to consider the impact that heavy seasonal
           demand would have on the EOQ model. If the heavy demand is to last for two months,
           the formula might be adjusted to assume annual sales based on this high level of
           demand. Total unit sales per year, T, in the (T/Q) component of total restocking cost
           would increase, suggesting a larger Q to minimize restocking costs. However, as Q
           increases, the (T/Q) component of restocking costs falls but the (Q/2) component of
           carrying costs would rise. Thus, we are finding a new optimal order quantity by trading
           off these two costs. The instructor could also offer the students the basic intuition that if
           sales increase and no additional inventory is purchased, inventory turnover would
           increase and the students should remember that high levels of inventory turnover imply
           the danger of a stock-out. Finally, when seasonal demand is low, T would be determined
           based on a monthly average of low sales. It should be emphasized that the EOQ model
           assumes a steady rate of sales throughout the year. If sales are not constant, an
           adjustment may have to be applied to the formula.
           Note: The EOQ model is an ‘inventory’ model of the BAT cash management model
           discussed in Chapter 19.

           EOQ—the quantity which minimizes the total cost associated with inventory carrying
           costs and restocking costs.

S20.23: Economic Order Quantity (EOQ) Model, Example and Extensions (3 pages)

           Total carrying costs
               = Average inventory × Carrying costs per unit
               = (Q/2) × CC

           Total restocking costs
               = Fixed cost per order × Number of orders
               = F × (T/Q)

           Total costs = Carrying costs + Restocking costs

               = (Q/2) × CC + F × (T/Q)

                      2T  F
            EOQ 

     C. Extensions to the EOQ Model

           EOQ tells the manager the optimal amount to reorder, but she must also consider:

              1. safety stocks—minimum level of inventory a firm must keep on hand.
              2. reorder points—to allow for delivery time.

       D. Managing Derived-Demand Inventories
              1. Materials Requirements Planning (MRP)
              2. Just-in-Time Inventory (JIT)

                  As noted in the text, the primary advantage of a JIT system is the reduction in
              inventory carrying costs which, for a large manufacturing firm, can be substantial. As
              with every financial decision, however, there is no increase in return without a
              commensurate increase in risk. In this instance, the risk is that an interruption in the
              supply of inventory items will require the user to shut down production. As part of a
              larger program to reduce costs, General Motors adopted a variant of the Just-in-Time
              system, but found it necessary to temporarily halt production of some models of
              automobiles in early 1994 and again in 1996 as a result of labor strikes at suppliers'



  S20.26: More on Credit Policy Analysis – Appendix 20A

       A. Two Alternative Approaches
              1. The One-Shot Approach
                  No switch cash flow: (P – v) Q
                  Switch cash flow: invest v Q  now, receive P Q  next period
                  Present value of switch net cash flow: P Q  /(1 + R) – v Q 

              The NPV equals

              Switch net benefit – No switch cash flow = [P Q  /(1 + R) – v Q  ] – (P – v) Q

              If repeated every period, the firm gets the NPV now and in every period, giving:
                      [P Q  /(1 + R) – v Q  ] – (P – v) Q + {[P Q  /(1 + R) – v Q  ] – (P – v) Q }/R

              This reduces to: – [P Q + v( Q  – Q )] + (P – v) ( Q  – Q )/R.

              2. The Accounts Receivable Approach

    Periodic benefit: (P – v)×( Q  – Q )
    Incremental investment in receivables: P Q + v( Q  – Q )
    Carrying cost per period: [P Q + v( Q  – Q )] × R
    Net benefit per period: (P – v) ×( Q  – Q ) – {[PQ + v( Q  – Q )] × R}

NPV = ((P – v) ( Q  – Q ) – {[PQ + v( Q  – Q )] × R})/R

This reduces to: – [P Q + v( Q  – Q )] + (P – v) ( Q  – Q )/R.
    Suppose we had the following for Giffie International, which is considering a change
from no credit to terms of net 20.

      P        = $100                 Q      = 1,050
      V        = $75                  R       = 1.5% per 20 days
      Q        = 1,000

Using the original method:

NPV       = –[P Q + v( Q  – Q )] + (P – v) ( Q  – Q )/R
NPV       = –[$100 × 1,000 + $75(1,050 – 1,000)]
            + ($100 – $75)(1,050 – 1,000)/.015
          = –$20,416.67

Using the one-shot approach:

NPV = [P Q  /(1+R) – v Q  ] – (P – v) Q + {[P Q  /(1+R) – v Q  ] – (P – v) Q }/R
NPV = [($100 × 1,050)/1.015 – $75 × 1,050] – ($100 – $75) × 1,000
      + {[($100 × 1,050)/1.015 – $75 × 1,050] – ($100 – $75) × 1,000}/.015
    = – $20,416.66

Using the accounts receivable approach:

NPV       = ((P – v) × ( Q  – Q ) – {[PQ + v( Q  – Q )] × R})/R
NPV       = (($100 – $75) × (1,050 – 1,000) –
            {[$100 × 1,000 + $75(1,050 –1,000)] × .015})/.015
          = – $20,416.66

To break even, Giffie needs (P Q )/[(P – v)/R – v] = 63 additional units.

    B. Discounts and Default Risk

                    = percentage of credit sales that go uncollected
              d      = percentage discount allowed for cash customers
              P     = credit price (no-discount price)
              P      = cash price = P(1  d )

           Assume no change in Q , then:

           Net incremental CF = [(1 –  ) P  – v] × Q – (P – v) × Q = P Q × (d –  )

               NPV = –P Q + P Q × (d –  )/R

           A break-even application:  = d – R × (1 – d) is the break-even default rate.

S20.27: Quick Quiz

S20.28: Summary


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