1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-1 Chapter Fourteen Credit Management

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-2 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 Chapter Organisation

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-3 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.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-4 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

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-5 Credit sale is made Customer mails cheque Firm deposits cheque in bank Bank credits firm’s account Cash collection Accounts receivable Time Cash Flows from Granting Credit

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-6 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.

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-7 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.

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-8 Cost of the Credit 2/10, net 30 = buyer pays in 10 days to get a 2 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. The benefit obviously lies in paying early.

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-9 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.

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-10 Evaluating a Proposed Credit Policy P = price per unitQ’ = new quantity expected to be sold v = variable cost per unitQ = current quantity sold per period R = periodic required return The benefit of switching is the change in cash flow:

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-11 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

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-12 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 = $55v = $32Q = 160 Q’ = 175R = 2%

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-13 Solution—Evaluating a Proposed Credit Policy

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-14 Solution—Evaluating a Proposed Credit Policy

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-15 Solution—Evaluating a Proposed Credit Policy Therefore, the switch is very profitable.

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-16 Break-even Point The switch is a good idea as long as the company can sell an additional 7.87 units.

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-17 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 (  ). All other information remains unchanged. Should the company switch to the credit policy?

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-18 Discounts and Default Risk NPV of changing credit terms: As the NPV of the change is negative, ABC Co. should not switch.

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-19 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.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-20 Optimal Credit Policy

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-21 Credit Analysis Process of deciding which customers receive credit. One-time sale—risk is variable cost only. Repeat customers—benefit is gained from one- time sale in perpetuity. Grant credit to almost all customers once as long as variable cost is low relative to price (high markup).

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-22 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.

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 14-23 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.