Lecture05 - FIN2101 FIN2101 Business Finance II Module 4...

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Unformatted text preview: FIN2101 FIN2101 Business Finance II Module 4 Module 4 Working Capital Management (Week 2) Student Activities (Receivables) Student Activities (Receivables) Reading Text, Chapter 17 (pp. 616­31, 633­4 only) Text Study Guide, Chapter 17 (part only) Study Book, Module 4.4 (pp. 4.20 to 4.26) Tutorial Activities Tutorial Workbook, Self Assessment Activity 4.3 Text Study Guide, Chapter 17, T/F 1­6, MC 1­8 & 10, Problems 1 to 5 Student Activities (General) Student Activities (General) Reading Text, Chapter 15 (pp. 544­9 only) Text Study Guide, Chapter 15 (part only) Study Book, Module 4.1 (pp. 4.1 to 4.4) Tutorial Work Tutorial Workbook, Self Assessment Activity 4.1 Text Study Guide, Chapter 15, T/F 1 & 2, MC 1­3, Problem 1 Credit Management Decisions Credit Management Decisions Do we grant credit? If so, to whom? On what terms? credit period cash discount discount period Credit Management Objectives Credit Management Objectives Maximise the probability of receipt Accelerate receipt Costs of Granting Credit Costs of Granting Credit Opportunity cost Administration costs Bad debts Additional inventory Discounted value of sale Benefit of Granting Credit Benefit of Granting Credit Additional sales Costs of NOT Granting Credit Costs of NOT Granting Credit Foregone sales Higher security costs Higher insurance costs Loss of customer goodwill Benefits of NOT Granting Credit Benefits of NOT Granting Credit Accelerated cash flows No bad debts or delinquent accounts Credit Selection Credit Selection It involves the decision whether to extend credit to a customer and how much credit to extend. It has the dimensions of credit analysis and credit standard A credit applicant’s creditworthiness can be assessed using the five C’s of credit – character, capacity, capital, collateral and conditions – see page 618 of text. Character and capacity are the two basic requirements for extending credit to a customer. Credit Analysis Credit Analysis It involves the collection and evaluation of credit information on credit applicants to determine while they can meet the firm’s credit standard The evaluation of credit applicants. Line of credit is the maximum amount a credit customer can owe at any one time. Credit scoring involves ranking an applicant’s overall credit strength on the basis of key financial and credit characteristics – see example on page 621 of the text. Credit Information Sources Credit Information Sources Common for applicant to fill out an application form. Additional information can be obtained from various sources: financial statements credit bureaus, eg Dun & Bradstreet Credit Reference Association of Australia applicant’s bank Credit Standards Credit Standards The minimum requirements for extending credit to a customer. The impact of varying credit standards on key variables – sales volume, investment in accounts receivables and bad debts – must be examined. Table on page 623 of text. Very high standards will lead to virtually no bad debts but will probably result in lost sales. Credit Terms Credit Terms Specify the repayment terms required of a firm’s credit customers. Credit terms are: cash discount, if any cash discount period credit period Varying any of the credit terms may affect the firm’s overall profitability – see pp. 626­9 of the text. Collection Policy Collection Policy The procedures for collecting a firm’s accounts receivable when they are due. A balanced approach is essential. Ageing of accounts receivable identifies the proportion of receivables that has been outstanding for a specified period of time. Increased collection efforts should reduce the investment in receivables and the level of bad debts, but may also lead to lost sales if the collection effort is too intense. Collection Techniques Collection Techniques Letters Telephone calls Personal visits Collection agencies Legal action Financial Evaluation of Credit Financial Evaluation of Credit Decisions n NPV = ∑ ( CFt × PVIFk, t ) - II t =1 Example 1 Example 1 Terms Sales Expenses urrent Cash Only $ 80 000 $48 000 ew 5/30, n/60 $100 000 $60 000 crement $ 20 000 $12 000 ate of return on investment is 1.25% per month. ssumptions: . Credit terms offered to new customers only. . 60% will take the discount (ie 60% of new sales). . Remainder will pay in 60 days. hould the firm introduce the new credit policy? 20 000 × 0.6 × 0.95 20 000 × 0.4 NPV = + - 12 000 2 1.0125 (1.0125) = 11 259 + 7 804 - 12 000 = $7 063 Decision: Introduce new policy. Decision: Introduce new policy. Example 2 Example 2 Current: Cash only Sales $400 000 p.a. New: Credit Sales $600 000 p.a. Payments Schedule Within 1 month of sale Within 2 months of sale Within 3 months of sale Bad debts 35% 40% 20% 5% Other data for Example 2: Variable costs are 80% of sales Req’d rate of return is 1% per month All customers will switch to credit terms. Required: Using the NPV approach, should management proceed with the proposed switch to a credit policy? 600000 × 0.35 600000 × 0.4 600000 × 0.2 NPV = + + - 480000 2 3 1.01 (1.01) (1.01) 210000 240000 120000 = + + - 480000 2 3 1.01 (1.01) (1.01) = 207 921 + 235 271 + 116 471 - 480 000 = $79 663 NPV of credit policy is $79 663. NPV of cash only policy is $80 000. Conclusion: Do not proceed with credit terms. Example 3 Example 3 Present level of sales p.a. Average collection period Sale price Variable costs Req’d rate of return Assume 360 days per year. $1.2m 30 days $10/unit $8/unit 25%p.a. Option Increase in ACP Increase in Sales To 45 days 15 $100 000 To 60 days 30 $150 000 Should the firm extend its average collection period? If so, to 45 days or 60 days? Solution Solution Increase in A.C.P. 15 days 1. Additional profit contribution from sales $20 000 (New sales x profit margin) 2. Beginning level of receivables $100 000 {Existing Sales/(360/Existing A.C.P.)} Increase in A.C.P. 15 days 3. Receivables level after change in policy $162 500 {New Sales/(360/New A.C.P.)} 4. Additional receivables $ 62 500 (3. - 2.) 5. Additional investment in receivables (4. x variable cost %) $ 50 000 Increase in A.C.P. 15 days 1. Additional profit contribution from sales $20 000 6. Required return on additional investment $12 500 (5. x 0.25) 7. Net advantage (1. - 6.) $7 500 Increase in A.C.P. 15 days 30 days 1. Additional profit contribution from sales $20 000 $10 000 (New sales x profit margin) 2. Beginning level of receivables $100 000 {Existing Sales/(360/Existing A.C.P.)} $162 500 Increase in A.C.P. 15 days 30 days 3. Receivables level after change in policy $162 500 $225 000 {New Sales/(360/New A.C.P.)} 4. Additional receivables $ 62 500 $ 62 500 $ 50 000 $ 50 000 (3. - 2.) 5. Additional investment in receivables (4. x variable cost %) Increase in A.C.P. 15 days 30 days 1. Additional profit contribution from sales $20 000 $10 000 6. Required return on additional investment $12 500 $12 500 $7 500 ($2 500) (5. x 0.25) 7. Net advantage (1. - 6.) Example 3 Extended Example 3 Extended What if we assume that relaxing the average collection period to 45 days will result in an increase in bad debts from the current level of 0.5% of sales to 1% of sales? Should the firm still increase the ACP to 45 days? Net advantage Current policy bad debts $7 500 $ 6 000 ($1.2m x 0.005) New policy bad debts $13 000 ($1.3m x 0.01) Increase in bad debts $7 000 Revised net advantage $ 500 Inventory and Receivables Inventory and Receivables There is a close relationship between inventory and accounts receivable. A decision to grant credit can result in increased sales, which must be supported by higher levels of inventory and accounts receivable. Their management should not be viewed independently! Working Capital in General Working Capital in General Management of current assets should not be left to itself. Around 40% of a firm’s total assets are in current asset form. Efficient management is of vital importance. Some Evidence Some Evidence 20­25% of new businesses fail in first 5 years. 80% of these show evidence of poor working capital management, particularly in the areas of inventory and accounts receivable. Reasons Reasons Integration factor Failure to recognise the integration of the three major types of current assets. Cost factor General ignorance of the cost involved in working capital. Objective Objective To have enough of a particular asset to meet its operating needs for that asset and to minimise the cost of having that asset. The balanced approach. Operating Cycle Operating Cycle Extends from the time of purchase of raw materials to the collection of accounts receivable. The longer the operating cycle, the greater the investment in current assets. A small increase in the level of investment in current assets will bring about an increase in benefits and an increase in costs. Optimal Policy Optimal Policy One which equates the increasing costs with the increased benefits. ...
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