27 16 chapter 27 providing and obtaining credit with

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Unformatted text preview: we can now analyze the profitability of the proposed change using Equation 27-3: P (SN S0)(1 V) r( I) (BNSN B0S0) (DNSNPN D0S0P0) ($130,000 $150,000)(0.4) 0.10( $4,548) [(0.02)($130,000) (0.02)($150,000)] $0 $8,000 $455 $400 $7,145. Since the expected incremental pre-tax profits are negative, the firm should not reduce its credit period from 30 to 20 days. Changes in Other Credit Policy Variables In the preceding section, we examined the effects of changes in the credit period. Changes in other credit policy variables may be analyzed similarly. In general, we would follow these steps: Step 1. Estimate the effect of the policy change on sales, on DSO, on bad debt losses, and so on. Step 2. Determine the change in the firm’s investment in receivables. If the change will increase sales, then use Equation 27-1 to calculate I. Conversely, if the change will decrease sales, then use Equation 27-2. Step 3. Use Equation 27-3, or one of its variations, to calculate the effect of the change on pre-tax profits. If profits are expected to increase, the policy change should be made, unless it is judged to increase the firm’s risk by a disproportionate amount. Simultaneous Changes in Policy Variables In the preceding discussion, we considered the effects of changes in only one credit policy variable. The firm could, of course, change several or even all policy variables simultaneously. An almost endless variety of equations could be developed, depending on which policy variables are manipulated and on the assumed effects on sales, discounts taken, the collection period, bad debt losses, the existence of excess capacity, changes in credit department costs, changes in the variable cost percentage, and so on. The analysis would get “messy,” and the incremental profit equation would be complex, but the principles we have developed could be used to handle any type of policy change. Self-Test Questions Describe the incremental analysis approach for evaluating a proposed credit policy change. How can risk be incorporated into the analysis? The Cost of Bank Loans In Chapter 22 we discussed the various short-term bank loans that are typically available: promissory notes, informal lines of credit, and revolving credit agreements. The cost of bank loans varies for different types of borrowers at any given point in time and for all borrowers over time. Interest rates are higher for riskier borrowers, and rates are also higher on smaller loans because of the fixed costs involved in making and servicing loans. If a firm can qualify as a “prime credit” because of its size and financial strength, it can borrow at the prime rate, which at The Cost of Bank Loans 27-17 one time was the lowest rate banks charged. Rates on other loans are generally scaled up from the prime rate, but loans to very strong customers are now made at rates below prime. Thus, loans to smaller, riskier borrowers are generally stated to carry an interest rate of “prime plus some number of percentage points,” but loans to larger, less risky borrowers may have a rate stated as “prime minus some percentage points.” Bank rates vary widely over time depending on economic conditions and Federal Reserve policy. When the economy is weak, then (1) loan demand is usually slack, (2) inflation is low, and (3) the Fed also makes plenty of money available to the system. As a result, rates on all types of loans are relatively low. Conversely, when the economy is booming, loan demand is typically strong, the Fed restricts the money supply, and the result is high interest rates. As an indication of the kinds of fluctuations that can occur, the prime rate during 1980 rose from 11 percent to 21 percent in just four months, and it rose from 6 to 9 percent during 1994. The prime rate is currently (July 2003) 4.00 percent. Interest rates on other bank loans also vary, generally moving with the prime rate. The terms on a short-term bank loan to a business are spelled out in the promissory note. Here are the key elements contained in most promissory notes: 1. Interest only versus amortized. Loans are either interest-only, meaning that only interest is paid during the life of the loan, and the principal is repaid when the loan matures, or amortized, meaning that some of the principal is repaid on each payment date. Amortized loans are called installment loans. Note too that loans can be fully or partially amortized. For example, a loan may mature after 10 years, but payments may be based on 20 years, so an unpaid balance will still exist at the end of the 10th year. Such a loan is called a “balloon” loan. 2. Collateral. If a short-term loan is secured by some specific collateral, generally accounts receivable or inventories, this fact is indicated in the note. If the collateral is to be kept on the premises of the borrower, then a form called a UCC-1 (Uniform Commercial Code-1) is filed with the secretary of the state in which the collateral resides, along with a Security Agreement (also part of the Uniform Commercial Code) that describes the nature of the agreement. These filings prevent the borrower from using the same collateral to secure l...
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This document was uploaded on 01/20/2014.

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