FM8e- EOC Sol Ch21


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Providing and Obtaining Credit ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 21-1 The term “credit policy” embraces four variables: (1) credit period, (2) discount offered, including the discount percentage and when payment must be made to get the discount, (3) credit standards, and (4) collection policy. Customers like easy credit, so the easie r, or more relaxed , the credit policy, the higher sales will be. Conversely, a tighter credit policy will lower sales somewhat. To ease credit policy, a firm might do such things as increase the credit period from 30 days to 60 days, ease its credit standards so as to offer credit to weaker customers (who are likely to pay late or not at all), and use less tough collection methods to avoid offending customers. All of the easing actions would tend to increase annual sales, hence sales/day. The easing actions they would also increase the receivables collection period—increasing the time customers have to pay would obviously delay collections, and selling to weaker customers and being less tough on collections would mean also lead to slower payments. Furthermore, since the amount of accounts receivable is the product of annual sales times the collection period, and since they both increase, easing credit would increase the investment in accounts receivable: Accounts receivable = (Sales/day)*(Receivables Collection Period) If the company changed its discounts policy, this would have two somewhat offsetting effects. First, an increase in the discount would normally cause more customers to pay in time to take the discount, which would lower receivables. Similarly, since receivables are normally reported net of discounts, if discounts are raised, this tends to lower receivables. However, the higher discount would really mean a price reduction, which would increase sales and thus receivables. The first two effects would, generally, be stronger, hence increasing the discount would normally reduce receivables. It is impossible to state, as a generalization, what the effect of an easing or tightening of credit policy on profits would be. The increased sales from an easing is normally a positive, but negatives would include an increase in bad debts rise and an increase in the cost of carrying receivables. Conversely, tightening credit would hurt sales somewhat, but it would reduce the collection period and lower bad debts. The net effect of a credit policy change will depend on how these factors interact with the gross profits on sales. A detailed analysis is necessary to make a reasonable estimate about the effect of credit policy on profits, and even then the estimate could turn out to be incorrect. See the BOC model for an analysis of a proposed credit policy change. Answers and Solutions:
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This note was uploaded on 08/29/2009 for the course FM Finance taught by Professor Unknown during the Spring '09 term at DeVry Addison.

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