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A B C D E F G H I J K L
10/28/2015
JAN $100
FEB 200
MAR 300
Chapter 27. Mini Case for Providing and Obtaining Credit
Rich Jackson, a recent finance graduate, is planning to go into the wholesale building supply business with his brother,
Jim, who majored in building construction. The firm would sell primarily to general contractors, and it would start
operating next January. Sales would be slow during the cold months, rise during the spring, and then fall off again in
the summer, when new construction in the area slows. Sales estimates for the first 6 months are as follows (in
thousands of dollars):
The terms of sale are net 30, but because of special incentives, the brothers expect 30 percent of the customers (by
dollar value) to pay on the 10th day following the sale, 50 percent to pay on the 40th day, and the remaining 20 percent
to pay on the 70th day. No bad debt losses are expected, because Jim, the building construction expert, knows which
contractors are having financial problems.
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Predicted AR to
f. Construct aging schedules for the end of March and the end of June. Do these schedules properly measure
customers’ payment patterns? If not, why not?
g. Construct the uncollected balances schedules for the end of March and the end of June. Do these schedules
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A B C D E F G H I J K L
Month (1)
Credit Sales
for Month (2)
Receivables
at End of
Month
ADS (4) DSO (5)
January $100 $70
AR = 0.7(SALES IN THAT MONTH) + 0.2(SALES IN PREVIOUS MONTH).
Quarterly Statement
the remaining 20 percent pay in the second month following the sale. Note that this is a different assumption than
was made earlier.
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March $500 $350 70%
$410 90%
Quarter 2:
April $400 $0 0%
May $300 $60 20%
June $200 $140 70%
$200 90%
To begin the analysis, describe the four variables which make up a firm’s credit policy, and explain how each of
them affects sales and collections. Then use the information given in part h to answer parts i through n.
The brothers are now considering a change in the firm’s credit policy. The change would entail (1) changing the
credit terms to 2/10, net 20, (2) employing stricter credit standards before granting credit, and (3) enforcing
collections with greater vigor than in the past. Thus, cash customers and those paying within 10 days would receive a
2 percent discount, but all others would have to pay the full amount after only 20 days. The brothers believe that the
discount would both attract additional customers and encourage some existing customers to buy more from the firm–
after all, the discount amounts to a price reduction. Of course, these customers would take the discount and, hence,
would pay in only 10 days.
The net expected result is for sales to increase to $1,100,000; for 60 percent of the paying customers to take the
discount and pay on the 10th day; for 30 percent to pay the full amount on day 20; for 10 percent to pay late on day 30;
and for bad debt losses to fall from 2 percent to 1 percent of gross sales. The firm’s operating cost ratio will remain
unchanged at 75 percent, and its cost of carrying receivables will remain unchanged at 12 percent.
Finally, collection policy refers to the procedures that the firm follows to collect past-due accounts. These can
range from a simple letter or phone call to turning the account over to a collection agency.
How the firm handles each element of credit policy will have an influence on sales, speed of collections, and bad
debt losses. The object is to be tough enough to get timely payments and to minimize bad debt losses, yet not to
create ill will and thus lose customers.
Current situation: the firm’s average daily sales currently amount to $1,000,000/365 = $2,739.73. The DSO is 32 days,
so accounts receivable amount to 32($2,73973) = $87,671. However, only 75 percent of this total represents cash
costs–the remainder is profit–so the investment in receivables (the actual amount that must be financed) is
Current situation: under the current, no discount policy, the cost of discounts is $0.
New situation: of the $1,100,000 gross sales expected under the new policy, 1 percent is lost to bad debts, so good
sales = 0.99($1,100,000) = $1,089,000. Since 60 percent of the good sales are discount sales, discount sales =
0.6($1,089,000) = $653,400. Finally, the discount is 2 percent, so the cost of discounts is expected to be 0.02($653,400)
= $13,068.
j. Under the current credit policy, what is the firm’s days sales outstanding (DSO)? What would the expected DSO be
if the credit policy change were made?
l. What would be the firm’s expected dollar cost of granting discounts under the new policy?
Old (current) situation: DSO0 = 0.8(30) + 0.2(40) = 32 days. New situation: DSOn = 0.6(10) + 0.3(20) + 0.1(30) = 15
days. Thus, the new credit policy is expected to cut the DSO in half.
Old (current) situation: BDLo = 0.02($1,000,000) = $20,000. New situation: BDLn = 0.01($1,100,000) = $11,000. Thus,
the new policy is expected to cut bad debt losses sharply.
k. What is the dollar amount of the firm’s current bad debt losses? What losses would be expected under the new
June
i. Assume now that it is several years later. The brothers are concerned about the firm’s current credit terms, which
are now net 30, which means that contractors buying building products from the firm are not offered a discount, and
they are supposed to pay the full amount in 30 days. Gross sales are now running $1,000,000 a year, and 80 percent
(by dollar volume) of the firms paying customers generally pay the full amount on day 30, while the other 20 percent
pay, on average, on day 40. Two percent of the firm’s gross sales end up as bad debt losses.
Cash discounts generally produce two benefits: (1) they attract both new customers and expanded sales from
current customers, because people view discounts as a price reduction, and (2) discounts cause a reduction in the
days sales outstanding, since both new customers and some established customers will pay more promptly in order
to get the discount. Of course, these benefits are offset to some degree by the dollar cost of the discounts
themselves.
The credit period is the length of time allowed to all “qualified” customers to pay for their purchases. In order to
qualify for credit in the first place, customers must meet the firm’s credit standards. These dictate the minimum
acceptable financial position required of customers to receive credit. Also, a firm may impose differing credit limits
depending on the customer’s financial strength as judged by the credit department.
The four variables which make up a firm’s credit policy are (1) the discount offered, including the amount and period;
(2) the credit period; (3) the credit standards used when determining who shall receive credit, and how much credit;
and (4) the collection policy.
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A B C D E F G H I J K L
Current situation Proposed situation
Sales 1,000,000$ Sales
$1,100,000
ADS = $ 2,739.73 ADS = $ 3,013.70
DSO = 32 days DSO = 15 days
AR= $ 87,671.23 AR= $45,205.48
Amt Financed $ 65,753.42 Amt Financed $33,904.11
Cost of financing $ 7,890.41
Cost of
financing $ 4,068.49
costs–the remainder is profit–so the investment in receivables (the actual amount that must be financed) is
0.75($87,671) = $65,753. At a cost of 12 percent, the annual cost of carrying the receivables is 0.12($65,753) = $7,890.
new situation: the cost of carrying the receivables balance under the new policy would be $4,068:
($1,100,000/365)(15)(0.75)(0.12) = $4,068.
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A B C D E F G H I J K L
Desired loan amount = $100,000
Quoted interest rate = 8%
(1) Simple interest:
The effective rate of an annual loan:
Effective rate assuming simple interest is the same as its quoted rate if annual compounding:
Effective rate = 8.00%
If the loan is for 90 days and renewable:
Number of compoundings a year =
4
Effective rate = 8.24%
Amount of loan to provide desired usable funds:
The full proceeds are usable.
Amount required to get desired level of usable funds = $100,000
(2) Discount interest:
The effective rate of an annual loan:
Interest charge = $8,000
Cash to be received = 92,000.00
Effective rate of loan = 8.70%
If the loan is for 90 days and renewable:
Interest charge = $2,000
Cash to be received = 98,000.00
Effective qtly rate of loan = 2.04%
Effective annual rate = 8.42%
Amount of loan to provide desired usable funds:
Amount needed = 100,000.00
Interest rate = 8%
Amount to borrow = $108,695.65
(3) discount interest with a 10 percent compensating balance.
compensating bal. % = 10%
The effective rate of an annual loan:
Interest charge = $8,000
Comp. Balance = 10,000.00
Cash received = 82,000.00
Cash repaid at end of loan = 90,000.00
Effective rate of loan = 9.76%
If the loan is for 90 days and renewable:
Interest charge = $2,000
Comp. Balance = 10,000.00
Cash received = 88,000.00
Cash repaid at end of loan = 90,000.00
Effective qtly rate of loan = 2.2727%
Effective annual rate = 9.41%
Amount of loan to provide desired usable funds:
Loan Amount = 100,000.00
Interest rate = 8%
Comp. Balance = 10%
Amount Received = 82,000.00
Amount needed = 100,000.00
compensating balance, and (4) add–on interest on a 12–month installment loan. What is the effective annual cost rate
for each alternative? For the first three of these assumptions, what is the effective rate if the loan is for 90 days, but
renewable? How large must the face value of the loan amount actually be in each of the 4 alternatives to provide
$100,000 in usable funds at the time the loan is originated?
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A B C D E F G H I J K L
Loan Amount = $121,951.22
(4) Add-on interest on a 12-month installment loan.
Loan amount $100,000
Payments 12
Interest rate 8%
The effective rate of an annual loan:
Interest charge = $8,000
The interest charge is simply the interest rate times the loan amount.
Loan face value = $108,000 The sum of the loan amount and the interest charge.
Monthly pmt = $9,000.00 The loan face value amount divided by the numnber of payments.
Periodic rate = 1.204% The periodic rate as solved with the function wizard. N=12,PMT=$933.33,PV=-$10,000.
APR = 14.45% (periodic rate) x (number of payments)
Effective rate = 15.45%
(1 + periodic rate) ^ number of payments – 1
Amount of loan to provide desired usable funds:
The full proceeds are usable.
Amount required to get desired level of usable funds = $100,000
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