27 3 analyzing proposed changes in credit policy

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Unformatted text preview: cy: Incremental Analysis 27-13 Thus, changes in credit policy are analyzed by using either Equation 27-1 or 27-2, depending on whether the proposed change is expected to increase or decrease sales, and Equation 27-3. The rationale behind these equations will become clear as we work through several illustrations. Note that all the terms in Equation 27-3 need not be used in a particular analysis. For example, a change in credit policy might not affect discount sales or bad debt losses, in which case the last two terms of Equation 27-3 would both be zero. Note also that the form of the equations depends on the way in which the variables are first defined.5 Changing the Credit Period In this section, we examine the effects of changing the credit period, while in the following sections we consider changes in credit standards, collection policy, and cash discounts. Throughout, we illustrate the situation with data on Stylish Fashions Inc. Lengthening the Credit Period Stylish Fashions currently sells on a cashonly basis. Since it extends no credit, the company has no funds tied up in receivables, has no bad debt losses, and has no credit expenses of any kind. On the other hand, its sales volume is lower than it would be if credit terms were offered. Stylish is now considering offering credit on 30-day terms. Current sales are $100,000 per year; variable costs are 60 percent of sales; excess production capacity exists (so no new fixed costs would be incurred as a result of expanded sales); and the cost of capital invested in receivables is 10 percent. Stylish estimates that sales would increase to $150,000 per year if credit were extended, and that bad debt losses would be 2 percent of total sales. Thus, $100,000. $150,000. 60% 0.6. 1 0.6 0.4. 10% 0.10. 0 days. 30 days. Here we assume that all customers will pay on time, so DSO specified credit period. Generally, some customers pay late, so in most cases DSO is greater than the specified credit period. 0% 0.00. There are currently no bad debt losses. 2% 0.02. These losses apply to the entire $150,000 new level of sales. DN 0%. No discounts are given under either the current or the proposed credit policies. S0 SN V 1V r DSO0 DSON B0 BN D0 Since sales are expected to increase, Equation 27-1 is used to determine the change in the investment in receivables: I [(DSON DSO0)(S0/365)] V[(DSON)(SN S0)/365] [(30 0)($100,000/365)] 0.6[30($150,000 $8,219 $2,466 $10,685. $100,000)/365] 5For example, P0 and PN are defined as the percentage of total customers who take discounts. If P0 and PN were defined as the percentage of paying customers (excluding bad debts) who take discounts, then Equation 27-3 would become P (SN S0)(1 V) r( I) (BNSN B0S0) [DNSNPN(1 BN) D0S0P0(1 B0)]. Similarly, changing the definitions of B0 and BN would affect the third term of Equation 27-3, as we discuss later. 27-14 Chapter 27 Providing and Obtaining Credit Note that the first term, the increased investment in accounts receivable associated with old sales, is based on the full amount of the receivables, whereas the second term, the investment associated with incremental sales, consists of incremental receivables multiplied by V, the variable cost percentage. This difference reflects the facts (1) that the firm invests only its variable cost in incremental receivables, but (2) that it would have collected the full sales price on the old sales earlier had it not made the credit policy change. There is an opportunity cost on the profit and a direct financing cost associated with the $8,219 additional investment in receivables from old sales, but only a direct financing cost associated with the $2,466 investment in receivables from incremental sales. Looking at this another way, incremental sales will generate an actual increase in receivables of (DSON)(SN S0)/365 30($50,000/365) $4,110. However, the only part of that increase that has to be financed (by bank borrowing or from other sources) and reported as a liability on the right side of the balance sheet is the cash outflow required to support the incremental sales, that is, the variable costs, V($4,110) 0.6($4,110) $2,466. The remainder of the receivables increase, $1,664 of accrued before-tax profit, is reflected on the balance sheet not as some type of credit used to finance receivables, but as an increase in retained earnings generated by the sales. On the other hand, the old receivables level was zero, meaning that the original sales produced cash of $100,000/365 $273.97 per day, which was immediately available for investing in assets or for reducing capital from other sources. The change in credit policy will cause a delay in the collection of these funds, and hence will require the firm (1) to borrow to cover the variable costs of the sales, and (2) to forgo a return on the retained earnings portion, which would have been available immediately had the credit policy change not been made. Given I, we may now determine the incremental profit, P, associated with the pr...
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