Corporate finance 7e ross ch28

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 0
Some customers will pay on day 10 and take the discount.
$970
0
10
30
Other customers will pay on day 30 and forgo the discount.
$1,000
0
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
0

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 = 0. 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

2811

28.2 The Decision to Grant Credit:
Risk and Information
Consider a firm that is choosing between two alternative
credit policies:

“In God we trust—everybody else pays
cash.”
Offering their customers credit.
The only cash flow of the first strategy is
Q0 ×(P0 – C0)

McGraw-Hill/Irwin
Corporate Finance, 7/e

© 2005 The McGraw-Hill Companies, Inc. All Rights


2812

28.2 The Decision to Grant Credit:
Risk and Information

The expected cash flows of the credit strategy are:
–C0′ × Q0′
0
We incur costs up
front…

McGraw-Hill/Irwin
Corporate Finance, 7/e

h × Q0′ × P0′
1
…and get paid in 1 period
by h% of our customers.

© 2005 The McGraw-Hill Companies, Inc. All Rights


2813

28.2 The Decision to Grant Credit: Risk
and Information

The NPV of the cash only strategy is:
NPVcash = Q0 × (P0 – C0)
The NPV of the credit strategy is:
h × Q0′ × P0′
NPVcredit = –C0′ × Q0′ +
(1 + rB)
The decision to grant credit depends on four factors:
1. The delayed revenues from granting credit: P0′ × Q0′
2. The immediate costs of granting credit: C0′ × Q0′
3. The probability of repayment: h
4. The discount rate: rB
McGraw-Hill/Irwin
Corporate Finance, 7/e

© 2005 The McGraw-Hill Companies, Inc. All Rights


2814

Example of the Decision to
Grant Credit
A firm currently sells 1,000 items per month on a cash
basis for $500 each.
If they offered terms net 30, the marketing department
believes that they could sell 1,300 items per month.
The collections department estimates that 5% of credit
customers will default.
The cost of capital is 10% per annum.

McGraw-Hill/Irwin
Corporate Finance, 7/e

© 2005 The McGraw-Hill Companies, Inc. All Rights


2815

Example of the Decision to
Grant Credit
No Credit

Net 30

Quantity sold

1,000

1,300

Selling price

$500

$500

Unit cost

$400

$425

Probability of payment

100%

95%

Credit period (days)

0

30

Discount rate per annum

 

10%

 

The NPV of cash only = 1,000×($500 – $400) = $100,000
The NPV of Net 30:
–1,300×$425 +
McGraw-Hill/Irwin
Corporate Finance, 7/e

1,300×$500×0.95
(1.10)

30/365

= $60,181.58

© 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
1
,
300
$
425

)
(
1
.
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:
1. The selling firm has a cost advantage over other lenders.
2. The selling firm can engage in price discrimination.
3. The selling firm can obtain favorable tax treatment.
4. The selling firm has no established reputation for quality

products or services.
5. 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 5 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