Q: A firm currently
makes only cash sales. It estimates that allowing
trade credit on terms of net 30 would increase
monthly sales from 200 to 220 units per month.
The price per unit is $101 and the cost (in present
value terms) is $80. The interest rate is 1 percent
per month.
a. Should the firm change its credit policy?
b. Would your answer to (a) change if 5 percent
of all customers will fail to pay their bills
under the new credit policy?
c. What if 5 percent of only the new customers
fail to pay their bills? The current customers
take advantage of the 30 days of free credit but
remain safe credit risks.
Answer:
a. The firm should weigh many factors before extending
and allowing trade credit to its customers. Necessary
factors to consider are:
• The amount of extra sales the credit policy
would generate. In this example extra sales are
$ 2,020 (20 * $ 101).
• Profitability of the extra sales, for
this example the extra profit figure is $ 420.
Profit from cash sales
Sales (200 * $ 101) – Costs (200 * $80)
= $ 4, 200
Profit from projected sales after implementation
of credit policy
Sales (220 * $ 101) – Costs (220 * $ 80)
= $ 4,620
Therefore, extra profit generated from an increase
in sales
Current profit ($ 4,200) – Projected Profit
($ 4,620) = $420
However, this profit when adjusted for interest
costs would be:
Extra monthly profit ($420) – Monthly interest
cost [(220 * $80) * 1%] = $244
• The average debt collection period. The
firm has not provided any estimates of this figure
although it has stated its credit policy terms
as net 30 days which is a fairly strict policy
and can be expected to generate some bad debts.
The firm should make efforts to review the creditworthiness
of its customers after the credit policy has been
implemented.
• Finally the firm should asses the required
rate of return on the investment in debtors.
If all debtors take one months profit
Increase in debtors (20 * $ 101) = $ 2,020
Add Increase in stocks (20 * $ 80) = $ 1,600
Less increase in creditors = unknown figure
Net increase in working capital = $ 3,620
Return on extra investment = extra profit (420)
/ net increase in working capital (3,620) = 0.116
Therefore percentage return on extra investment
is 11.6%. This return figure would be much less
if the figure for the increase in creditors was
known. However, the rate of return on extra investment
should match the companies required rate of return
on its investment.
Since an extra profit of $ 244 is projected after
the implementation of the new credit policy, I
think the firm should changes its credit policy.
However, the rate of return on extra investment
seems to be low and should be a concern to the
firm if it is lower than the firms required rate
of return on its investments.
b. If 5 percent of all customers will fail to
pay their bills under the new credit policy:
Total bad debts = Total credit sales (220 * $
101) * 5% = $ 1,111
Monthly Profit
Sales ($22,220) – bad debts ($ 1,111) =
$ 21,109
Profit = Sales ($ 21,109) – Costs ($ 17,600)
= $ 3,509
After deducting interest cost of $ 176, the profit
figure is $ 3,333. This new profit is less than
the current monthly profit of $ 4,200 by $ 876.
Therefore the credit policy is not worthwhile.
c. If 5 percent of only the new customers fail
to pay their bills? The current customers take
advantage of the 30 days of free credit but remain
safe credit risks.
Extra monthly profit ($ 420) * bad debt rate (5%)
= $ 399
Increase in profit after introduction of credit
policy = $ 4,200 + $ 399 = $ 4,599
When adjusted for interest costs, $ 4, 599 - $
176 = $ 4,423
Therefore, an increase in profit of $ 223 has
occurred. This increase should be sufficient to
justify the implementation of the new credit policy.
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