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Mini Case: 27 - 29
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.
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?
k. What is the dollar amount of the firm's current bad debt losses? What losses
would be expected under the new policy?
l. What would be the firm's expected dollar cost of granting discounts under the
new policy?
website, in whole or in part.
m. What is the firm's current dollar cost of carrying receivables? What would it be
after the proposed change?
Answer: 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($2,739.73) =
($1,100,000/365)(15)(0.75)(0.12) = $4,068.
Mini Case: 27 - 31
n. What is the incremental after-tax profit associated with the change in credit
terms? Should the company make the change? (assume a tax rate of 40
percent.)
New Old Difference
Gross sales $1,000,000
Less discounts 0
Net sales $1,000,000
Production costs 750,000
Profit before credit
Costs and taxes $ 250,000
Credit-related costs:
Carrying costs 7,890
Bad debt losses 20,000
Profit before taxes $ 222,110
Taxes (40%) 88,844
Net income $ 133,266
Answer: The income statements and differentials under the two credit policies are shown
below:
Profit before credit
Costs and taxes $ 261,932 $ 250,000 $ 11,932
Credit-related costs:
Carrying costs 4,068 7,890 (3,822)
Bad debt losses 11,000 20,000 (9,000)
here, the $14,884 is also the incremental cash flow expected under the new policy.
However, the new policy is not riskless. If the firm's customers do not react as
predicted, then the firm's profits could actually decrease as a result of the change.
The amount of risk involved in the decision depends on the uncertainty inherent in the
estimates, especially the sales estimate. Typically, it is very difficult to predict
o. Suppose the firm makes the change, but its competitors react by making similar
changes to their own credit terms, with the net result being that gross sales
remain at the current $1,000,000 level. What would the impact be on the firm's
post-tax profitability?
Answer: If sales remain at $1,000,000 after the change is made, then the following situation
would exist:
Credit costs:
Carrying costs 3,699
Bad debt losses 10,000
Profit before taxes $ 224,421
Taxes (40%) 89,769
Mini Case: 27 - 33
p. The brothers need $100,000 and are considering a 1-year bank loan with a
quoted annual rate of 8%. The bank is offering the following alternatives: (1)
simple interest, (2) discount interest, (3) discount interest with a 10%
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?
Answer: 1. With a simple interest loan, they gets the full use of the $100,000 for a year, and
then pay 0.08($100,000) = $8,000 in interest at the end of the term, along with the
and the effective annual rate is 8.24 percent:
EARsimple = (1.02)4 - 1 = 1.0824 - 1 = 0.0824 = 8.24%.
In general, the shorter the maturity (within a year), the higher the effective
cost of a simple loan.
the effective annual rate is 8.7 percent:
000,8$
Note that a timeline can also be used to calculate the effective annual rate of the
1-year discount loan:
0 1
| |
If the loan were for 90 days:
Discount interest. If borrow $100,000 face value at a nominal rate of 8
percent, discount interest, for 3 months, then m = 12/3 = 4, and the interest
payment is (0.08/4)($100,000) = $2,000, so
i = ?
3. If the loan is a discount loan, and a compensating balance is also required, then
the effective rate is calculated as follows:
1.008.01
0 1
| |
121,951.22 -121,951.22
- 9,756.10 (discount interest) 12,195.12
-12,195.12 (compensating balance) -109,756.10
above, except that we must add the compensating balance term to the
denominator.
EAR =
1
000,10$000,2$000,100$
000,2$
0.1
4
= (1.0227)4 - 1 = 0.0941 = 9.41%
The face value (the amount of the loan required to get the desired level
of usable funds) of the loan is calculated as:
Face value =
CB-RATE NOMINAL1
REQUIRED FUNDS
=
10.008.01
000,100$
= $121,951.22.
i = ?
4. In an installment (add-on) loan, the interest is calculated and added on to the
amortized by equal payments over the stated life. Thus, the interest would be
$100,000 0.08 = $8,000, the face amount would be $108,000, and each monthly
payment would be $9,000: $108,000/12 = $9,000.
However, the firm would receive only $100,000, and it must begin to repay
the principal after only one month. Thus, it would get the use of $100,000 in the
