22
Chapter
Providing Chapter and Obtaining Credit
1
Focus Areas
Focus
Receivables
management
Credit policy
Days sales outstanding (DSO)
Aging schedules
Payments pattern approach
Cost
of bank loans
2
Elements of Credit Policy (a)
Elements
Cash Discounts
2. Credit Period
3. Credit Standards
4. Collection Policy
1.
3
What is the firms expected DSO
and average daily sales (ADS)? (b1
& b2)
b2)
DSO = 0.30(10) + 0.50(40) + 0.20(70)=
37days.
ADS = 18,000($100)
365
=$4,931.51 per day.
4
What is the expected average accounts
receivable level? How much of this amount
must be financed if the profit margin is 25%?
(b3/b4)
(b3/b4)
A/R = (DSO)(ADS) = 37($4,931.51)
= $182,466
0 .75($182,466) = $136,849.
5
If notes payable are used to finance the A/R
investment, what does the firms balance
sheet look like? (b4)
sheet
Assets
A/R
Liabilities&Equity
$182,466
Notespayable
Retained
earnings
$136,849
45,617
$182,466
6
If bank loans cost 12 percent, what is the
annual dollar cost of carrying the
receivables? (b5)
receivables?
Cost
of carrying receivables
= 0.12($136,849)
= $16,422.
In addition, there is an opportunity
cost of not having the use of the profit
com-ponent of the receivables.
7
What are some factors which
What
iinfluence a firms receivables level?
nfluence
The dollar cost of carrying receivables?
The
(c)
(c)
Receivables
are a function of average daily
sales and days sales outstanding.
State of the economy, competition within the
industry, and the firms credit policy all
influence a firms receivables level.
The
lower the profit margin, the higher the
cost of carrying receivables, because a
greater portion of each sales dollar must be
financed.
The higher the cost of financing, the higher
the dollar cost.
8
What would the receivables level
be at the end of each month? (d)
be
A/R=0.7(Salesinthatmonth)+0.2(Salesin
previousmonth).
Month
Sales
A/R
January
$100
$70
February
200
160
March
300
250
April
300
270
May
200
200
June
100
110 9
What is the firms forecasted average daily sales
(ADS) for the first 3 months? For the entire half(ADS)
year? (assuming 91-day quarters) (e)
Avg. Daily Sales = Total Sales
# of days
1st Qtr: $600/91= $6.59
2nd Qtr: $600/91= $6.59
10
What DSO is expected at the end of
March? At the end of June? (e)
March?
A/R
DSO =
.
ADS
1st Qtr: $250/$6.59 = 37.9 days.
2nd Qtr: $110/$6.59 = 16.7 days.
11
What does the DSO indicate about
customers payments? (e)
customers
It
appears that customers are paying
significantly faster in the second
quarter than in the first.
However, the receivables balances
were created assuming a constant
payment pattern, so the DSO is giving
a false measure of payment
performance.
Underlying cause is seasonal
variation.
12
Construct an aging schedule for the
end of March and the end of June. (f)
end
Ageof
account
March
June
(Days)
A/R
%
A/R
%
030
3160
6190
$210
40
0
$250
84%
16
0
100%
$70
40
0
$110
64%
36
0
100%
13
Uncollected Balances Schedules
for the End of March (g)
for
Contrib.
A/Rto
Sales
Months
Sales
January
$100
$0
0%
February
200
40
20
March
300
210
70
$250
90%
EndofQtr.A/R
toA/R
14
Uncollected Balances
Schedules for the End of June
(g)
(g)
Months
Sales
Contrib.
toA/R
A/Rto
Sales
April
$300
$0
0%
May
200
40
20
June
100
70
70
$110
90%
EndofQtr.A/R
15
Do the uncollected balances schedules
properly measure customers payment
patterns? (g)
patterns?
Focal
point of the uncollected
balances
Ratio changes
Customers payment patterns
Increases in the A/R to sales ratio
The bottom line
16
June 30
June
Months
Predicted
Predicted
Sales Predicted
A/RtoSales Contribution
Ratio
toA/R
0%
$400
$0
April
May
300
20
June
200
70
ProjectedJune30A/Rbalance
60
140
17
$200
What four variables make up
a firms credit policy?
firms
Cash
discounts
Credit period
Credit standards
Collection policy
18
(i)
Current
credit policy:
Credit terms = Net 30.
Gross sales = $1,000,000.
80% (of paying customers) pay on Day
30.
20% pay on Day 40.
Bad debt losses = 2% of gross sales.
Operating
cost ratio = 75%.
Cost of carrying receivables = 12%.
19
The firm is considering a change in
credit policy (i)
credit
New
credit policy:
Credit terms = 2/10, net 20.
Gross sales = $1,100,000.
60% (of paying customers) pay on Day
10.
30% pay on Day 20.
10% pay on Day 30.
Bad debt losses = 1% of gross sales.
20
What is the DSO under the current and
the new credit policies? (j)
the
Current:
DSO0 = 0.8(30) + 0.2(40)
= 32 days.
New:
DSON = 0.6(10) + 0.3(20) + 0.1(30)
= 15 days.
21
What are bad debt losses under the
current the and new credit policies? (k)
current
Current:
BDL0 = 0.02($1,000,000)
= $20,000.
New:
BDLN = 0.01($1,100,000)
= $11,000.
22
What are the expected dollar costs of
discounts under the current and the new
policies? (l)
policies?
Discounto
= $0.
DiscountN
= 0.6(0.02)(0.99)
($1,100,000)
= $13,068.
23
What are the dollar costs of carrying
receivables under the current and the new
policies? (m)
policies?
Costs
of carrying receivablesO
=($1,000,000/365)(32)(0.75)(0.12)
=$7,890.
Costs of carrying receivablesN
=($1,100,000/365)(15)(0.75)(0.12)
=$4,068.
24
What is the incremental after-tax profit
associated with the change in credit terms?
(n)
(n)
New
GrossSales
Less:Disc.
NetSales
Production
costs
Profitbefore
creditcosts
Old
Difference
$1,100,000
$1,000,000
$100,000
13,068
0
13,068
$1,086,932
$1,000,000
$86,932
825,000
750,000
75,000
$261,932
$250,000
25
$11,932
Should the company make the
change? (n)
change?
Prof.bef.creditcosts
andtaxes
Creditrelatedcosts
Carryingcosts
Baddebts
Profitbeforetaxes
Taxes(40%)
Netincome
New
Old
Diff.
$261,932 $250,000 $11,932
4,068
7,890
(3,822)
11,000
20,000
(9000)
$246,864 $222,110 $24,754
98,745 88,844 9,902
$148,118 $133,266 $14,852
26
With change in policy.. (o)
With
Grosssales
Less:discounts
Netsales
$1,000,000
11,880
$988,120
Productioncosts
750,000
Pretaxop.profit
$238,120
Carryingcosts
Baddebtlosses
Profitbeforetaxes
Taxes
NetIncome
3,699
10,000
$224,421
89,769
$134,653
27
A bank is willing to lend the brothers $100,000 for 1
year at an 8 percent nominal rate. What is the EAR
under the following five loans? (p)
under
Simple annual interest, 1 year.
Simple
interest, paid monthly.
Discount interest.
Discount interest with 10 percent
compensating balance.
Installment loan, add-on, 12 months.
28
Why must we use Effective Annual
Rates (EARs) to evaluate the loans? (p)
Rates
In
our examples, the nominal (quoted)
rate is 8% in all cases.
We want to compare loan cost rates
and choose the alternative with the
lowest cost.
Because the loans have different
terms, we must make the comparison
on the basis of EARs.
29
Simple Annual Interest, 1-Year
Loan (p)
Loan
Simple interest means no discount or add-on.
Interest = 0.08($100,000) = $8,000.
rNom = EAR =
$8,000 = 0.08 = 8.0%.
$100,000
On a simple interest loan of one year,
rNom = EAR.
30
Simple Interest, Paid Monthly
(p)
(p)
Monthly interest = (0.08/12)($100,000)= $666.67.
0
1
...
100,000 -666.67
12
N
12
-667.67
-100,000.00
100000 -666.67 -100000
I/YR
PV
PMT
FV
0.66667
31
(More)
rNom = (Monthly rate)(12)
= 0.66667%(12) = 8.00%.
1+ 0.08
EAR =
12
or: 12
12
P/YR, 8
1= 8.30%.
NOM%,
EFF% = 8.30%.
Note: If interest were paid quarterly, then:
0 . 08 4
EAR = 1+
1= 8.24%.
4
Daily, EAR = 8.33%.
32
8% Discount Interest, 1 Year
(p)
(p)
Interest deductible = 0.08($100,000) = $8,000.
Usable funds
= $100,000-$8,000 = $92,000.
0
1
i=?
92,000
-100,000
1
N
I/YR
92
PV
8.6957% = EAR
0
PMT
-100
FV
33
Discount Interest (Continued) (q)
Discount
Amt. borrowed =
Amount needed
1 - Nominal rate (decimal)
$100,000
= $108,696.
=
0.92
34
Need $100,000. Offered loan with terms of
8% discount interest, 10% compensating
balance. (p), (q)
balance.
Face amount of loan =
Amount needed
1 - Nominal rate - CB
= $100,000
1 - 0.08 - 0.1
= $121,951.
(More)
35
EAR correct only if amount is
borrowed for 1 year. (p)
borrowed
Interest = 0.08 ($121,951) = $9,756.
Cost = Interest paid
Amount received
$9,756
EAR = $100,000 = 9.756%.
36
8% Discount Interest with 10%
Compensating Balance (Continued) (p), (q)
(Continued)
0
121,951
-9,756
-12,195
100,000
1
i=?
Loan
Prepaid interest
CB
Usable funds
1
N
-121,951
+ 12,195
-109,756
100000 0 -109756
I/YR
PV PMT
FV
9.756% = EAR
This procedure can handle variations.
37
1-Year Installment Loan, 8%
Add-On (p)
Add-On
Interest
= 0.08($100,000) = $8,000.
Face amount = $100,000 + $8,000 =
$108,000.
Monthly payment = $108,000/12 = $9,000.
Average loan outstanding = $100,000/2 =
$50,000.
Approximate cost = $8,000/$50,000 =
16.0%.
(More)
38
Installment Loan (p)
Installment
To
find the EAR, recognize that the
firm has received $100,000 and must
make monthly payments of $9,000.
This constitutes an ordinary annuity as
shown below:
0
i=?
100,000
1
2
-9,000 -9,000
...
Months
12
-9,000
(More)
39
Find the monthly rate and the
annualized rate. (p)
annualized
12
N
100000 -9000
I/YR
PV PMT
0
FV
1.2043% = rate per month
rNom = APR = (1.2043%)(12) = 14.45%.
EAR = (1.012043)12 - 1 = 15.45%.
12
P/YR, 14.45
NOM%,
EFF% = 15.45%.
(More)
40