Introduction About Credit Management by jtv20765

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									Chapter 8: On Credit Management.

=======================================================================
 INTRODUCTION
==================

Analysis of credit management decisions is a nice application of capital budgeting
procedures. A relaxation of credit policies is likely to enable the firm to increase
price, increase quantity sold, but is likely to increase bad debt losses and the average
collection period – and the opposite for tightening credit policies. Relaxing credit
policies is, therefore, likely to increase revenues, but is also likely to involve tying up
a larger investment in accounts receivable – and the converse for tightening credit
policies. The framework developed enables us to make a rigorous capital budgeting
analysis of improvements in revenues versus tying up investment for a longer period



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                                                  9c21c05c-16e6-467e-8cbd-4fb8acc043f3.xls
==============================================================================
 QUESTIONS
===================
1) Firm A is proposing to relax its credit terms so that its average collection period rises from 40
   days to 50 days, while its daily sales rise from 200 to 260 units. Price per unit remains the
   same at $500; cost per unit remains the same at $350. The bad debt loss ratio rises from 2%
   to 3%. The daily interest rate is 0.05%. Enter these proposed changes in the table. Is the
   NPV of this change in credit terms positive or negative?

    a) If the bad debt loss ratio had risen to 4%, how would the NPV be affected?

    b) If the bad debt loss ratio had risen to 10%, how would the NPV be affected?

    c) If daily sales had increased to 350 units, but all other conditions were as in Question 1,
       how would NPV be affected?

    d) If the relaxation of credit terms had enabled the firm to raise its price from $500 to $550
       per unit, and all other conditions were as in the original Question 1, how would NPV be
       affected?

2) Now, going back to the original situation, Firm A changes its credit standards, so that it now
   accepts customers with financial profiles that are much weaker. As a consequence, it is able
   to increase its sales by 100 units (from 200 units to 300 units). The bad debt loss ratio,
   however, becomes five percent, and the average collection period on the incremental sales
   now becomes 60 days. Is the NPV of the policy change positive or negative?

    (Hint: For incremental sales, use only "Proposed Policy" and NPV1 equation to test whether
    incremental NPV is positive or negative.)

    a) To what would the bad debt loss ratio have to rise in order for the NPV of relaxing credit
       standards to become negative?

    b) How does this bad debt loss ratio compare to the contribution margin (sales minus
       variable costs)?

3) Suppose we now consider Firm B, for which the contribution margin is $50 per unit, instead of
   $150 per unit as in the above questions. Do the same analysis as in Question 2, 2a, and 2b.

4) Hamilton Fixtures is rethinking its credit policies. It has collected credit data on each of its
   major customers and wonders to which categories of customers it should relax credit
   restrictions. First, its customers must be sorted in order of their credit worthiness. Next, it
   must analyze the change in NPV from extending credit-to-credit categories 1-4. Which
   categories of customers should be offered credit?

5) Now repeat the same analysis for Brandon's deli and Jones' Van Detailing. Replace with new
   customers, sort in order of credit worthiness and analyze resulting NPVs for each of the four
   credit categories. Which categories of customers should be offered credit?

 6) Now make up your own question. You may vary price, cost, sales, bad debt rate, collection
==============================================================================
    period and interest rate. Compare current policy with any changes you might consider, as
    entered in "Proposed Policy".




                                                       9c21c05c-16e6-467e-8cbd-4fb8acc043f3.xls
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SUMMARY OF ASSUMPTIONS AND RESULTS
========================================                   Firm A
Factors                                     Current Policy        Proposed Policy

P = price per unit                      P0 =         $500      P1 =        $500

C = cost per unit                       C0 =         $350      C1 =        $350

Q = daily sales (units)                 Q0 =          200      Q1 =         260

b = bad debt loss rate                  b0 =         2.0%      b1 =        3.0%

t = average collection period (days)    t0 =          40       t1 =          50

k = daily interest rate                 k0 =        0.05%      k1 =       0.05%


                 Net Present Value         =       $26,060       =       $31,987
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                                         9c21c05c-16e6-467e-8cbd-4fb8acc043f3.xls
================================================================================
 DETAILED CALCULATIONS
===========================

           P  (    Q     )( 1 – b )
NPV =    ————————————————————                   –    C(Q)
                (1 + k)t


          $500 ( 200 )( 1 – 0.02 )
NPV0 =   ————————————————————                   –     $350 ( 200 )   =   #######
                                40
                   ( 1.0005 )


          $500 ( 260 )( 1 – 0.03 )
NPV1 =   ————————————————————                   –     $350 ( 260 )   =   #######
                                50
                   ( 1.0005 )

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                                         9c21c05c-16e6-467e-8cbd-4fb8acc043f3.xls
======================================================================
CREDIT CATEGORIES            | HISTORICAL DATA:    Average      Daily Sales
===================          |                     Collection    Unit Lost
Hamilton Fixtures     Credit |  Credit  Percentage  Period    Through Credit
Customers            Category| Category Bad Debts   (Days)     Restrictions
————————             ————| ———— —————              ————        ——————
ABC Electric              3 |
Condo Haven               1 |       1       0.5%         10             75
Cooperage                 4 |
Fast Food Paradise        4 | ________________________________________
Hair Unlimited            3 |
Now Gadgets               1 |       2       2.0%         15             60
Pacific Contractors       2 |
Rangers' Pub              4 | ________________________________________
Student Publications      3 |
Studio City               2 |       3      10.0%         40             70
Tans-R-Us                 1 | ________________________________________
Vacation Spa              2 |
Vintage Sweet Shoppe      1 |       4      20.0%         60             50
Zone Thirty               2 | ________________________________________

======================================================================
 CREDIT CATEGORIES          | HISTORICAL DATA:    Average      Daily Sales
===================         |                     Collection    Unit Lost
Brandon Deli         Credit |  Credit  Percentage  Period    Through Credit
Customers           Category| Category Bad Debts   (Days)     Restrictions
————————            ————| ———— —————              ————        ——————
Just Cheese              3 |
Pizza 'n Palms           1 |       1       5.0%           5            50
Ye Olde Pig              4 |
Deli-Grams               2 | ________________________________________
Smoke Chop               4 |
L.A. In-A-Day            1 |       2      12.0%         15             35
Sub-City                 3 |
Little Italy             4 | ________________________________________
Le Barnyard              1 |
Just Meats               1 |       3      25.0%         30             70
Sausage 'n Songs         4 | ________________________________________
Deli-Gate                1 |
Little Israel            3 |       4      30.0%         60             40
Just Borscht             4 | ________________________________________




                                       9c21c05c-16e6-467e-8cbd-4fb8acc043f3.xls
======================================================================
  CREDIT CATEGORIES         | HISTORICAL DATA:    Average      Daily Sales
===================         |                     Collection    Unit Lost
Jones Van Detailing  Credit |  Credit  Percentage  Period    Through Credit
Customers           Category| Category Bad Debts   (Days)     Restrictions
————————            ————| ———— —————              ————        ——————
Van World                1 |
Meyers' Chevy            4 |       1       5.0%         10             10
Big Hunk                 2 |
Wheels to Go             2 | ________________________________________
Westwood Ford            3 |
$ Million Motors         4 |       2      10.0%         20              8
Van Land                 1 |
Trucks & Such            1 | ________________________________________
Thompson Toyota          3 |
It's a Trip              4 |       3      20.0%         40             20
Born to Run              2 | ________________________________________
Discount Van Sales       2 |
Party on Wheels          1 |       4      30.0%         60             15
Ride-in-Style            3 | ________________________________________




                                       9c21c05c-16e6-467e-8cbd-4fb8acc043f3.xls
                    NET PRESENT VALUES


$35,000

                                                     $31,987


$30,000


          $26,060

$25,000




$20,000




$15,000




$10,000




 $5,000




    $0
          Current                                   Proposed
                            Credit Policy



                                            9c21c05c-16e6-467e-8cbd-4fb8acc043f3.xls

								
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