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28-1
McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights
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CHAPTER
28Credit
Management
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McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights
Reserved.
Chapter Outline
28.1 Terms of the Sale28.2 The Decision to Grant Credit: Risk and Information 28.3 Optimal Credit Policy28.4 Credit Analysis28.5 Collection Policy28.6 How to Finance Trade Credit28.7 Summary & Conclusions
28.1 Terms of the Sale28.2 The Decision to Grant Credit: Risk and Information 28.3 Optimal Credit Policy28.4 Credit Analysis28.5 Collection Policy28.6 How to Finance Trade Credit28.7 Summary & Conclusions
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Introduction
A firm’s credit policy is composed of:Terms of the sale
Credit analysis
Collection policy
This chapter discusses each of the componentsof credit policy that makes up the decision to grant credit.
A firm’s credit policy is composed of:Terms of the sale
Credit analysis
Collection policy
This chapter discusses each of the componentsof credit policy that makes up the decision to grant credit.
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The Cash Flows of Granting Credit
Credit sale is made
Customer mails check
Firm deposits check
Bank credits firm’s
account
Accounts receivable
Cash collection
Time
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28.1 Terms of the Sale
The terms of sale of composed ofCredit PeriodCash DiscountsCredit Instruments
The terms of sale of composed ofCredit PeriodCash DiscountsCredit Instruments
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Credit Period
Credit periods vary across industries.Generally a firm must consider three factors in setting a credit period:
The probability that the customer will not pay.The size of the account.The extent to which goods are perishable.
Lengthening the credit period generally increases sales
Credit periods vary across industries.Generally a firm must consider three factors in setting a credit period:
The probability that the customer will not pay.The size of the account.The extent to which goods are perishable.
Lengthening the credit period generally increases sales
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Cash Discounts
Often part of the terms of sale.Tradeoff between the size of the discount and the increased speed and rate of collection of receivables.An example would be “3/10 net 30”
The customer can take a 3% discount if he pays within 10 days.In any event, he must pay within 30 days.
Often part of the terms of sale.Tradeoff between the size of the discount and the increased speed and rate of collection of receivables.An example would be “3/10 net 30”
The customer can take a 3% discount if he pays within 10 days.In any event, he must pay within 30 days.
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The Interest Rate Implicit in 3/10 net 30
A firm offering credit terms of 3/10 net 30 is essentially offering their customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0
A firm offering credit terms of 3/10 net 30 is essentially offering their customers a 20-day loan.
To see this, consider a firm that makes a $1,000 sale on day 0
Some customers will pay on day 10 and take the discount.
Other customers will pay on day 30 and forgo the discount.0 10 30
$970
0 10 30
$1,000
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0 10 30
+$970 –$1,000
A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest:
The Interest Rate Implicit in 3/10 net 30
970$
000,1$)1( 36520 r
36520)1(
000,1$970$
r
%35.747435.01970$
000,1$ 20
365
r
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Credit Instruments
Most credit is offered on open account—the invoice is the only credit instrument.Promissory notes are IOUs that are signed after the delivery of goodsCommercial drafts call for a customer to pay a specific amount by a specific date. The draft is sent to the customer’s bank, when the customer signs the draft, the goods are sent.Banker’s acceptances allow a bank to substitute its creditworthiness for the customer, for a fee.Conditional sales contracts let the seller retain legal ownership of the goods until the customer has completed payment.
Most credit is offered on open account—the invoice is the only credit instrument.Promissory notes are IOUs that are signed after the delivery of goodsCommercial drafts call for a customer to pay a specific amount by a specific date. The draft is sent to the customer’s bank, when the customer signs the draft, the goods are sent.Banker’s acceptances allow a bank to substitute its creditworthiness for the customer, for a fee.Conditional sales contracts let the seller retain legal ownership of the goods until the customer has completed payment.
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28.2 The Decision to Grant Credit: Risk and Information
Consider a firm that is choosing between two alternative credit policies:
“In God we trust—everybody else pays cash.”Offering their customers credit.
The only cash flow of the first strategy is
Q0 ×(P0 – C0)
Consider a firm that is choosing between two alternative credit policies:
“In God we trust—everybody else pays cash.”Offering their customers credit.
The only cash flow of the first strategy is
Q0 ×(P0 – C0)
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28.2 The Decision to Grant Credit: Risk and Information
0 1
…and get paid in 1 period by h% of our customers.
The expected cash flows of the credit strategy are: The expected cash flows of the credit strategy are:
h × Q0 × P0′′
We incur costs up front…
–C0 × Q0′′
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28.2 The Decision to Grant Credit: Riskand Information
NPVcash = Q0 × (P0 – C0)
h × Q0 × P0′′
(1 + rB) –C0 × Q0
′′ +NPVcredit =
1. The delayed revenues from granting credit:
2. The immediate costs of granting credit:
3. The probability of repayment: h
4. The discount rate: rB
P0 × Q0′′
C0 × Q0′′
The NPV of the cash only strategy is:
The NPV of the credit strategy is:
The decision to grant credit depends on four factors:
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Example of the Decision toGrant Credit
A firm currently sells 1,000 items per month on a cash basis for $500 each.
If they offered terms net 30, the marketing department believes that they could sell 1,300 items per month.
The collections department estimates that 5% of credit customers will default.
The cost of capital is 10% per annum.
A firm currently sells 1,000 items per month on a cash basis for $500 each.
If they offered terms net 30, the marketing department believes that they could sell 1,300 items per month.
The collections department estimates that 5% of credit customers will default.
The cost of capital is 10% per annum.
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Example of the Decision toGrant Credit
The NPV of cash only = 1,000×($500 – $400) = $100,000
No Credit Net 30 Quantity sold 1,000 1,300
Selling price $500 $500
Unit cost $400 $425
Probability of payment 100% 95%
Credit period (days) 0 30
Discount rate per annum 10%
The NPV of Net 30:
1,300×$500×0.95–1,300×$425 +
(1.10)30/365= $60,181.58
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Example of the Decision toGrant Credit
How high must the credit price be to make it worthwhile for the firm to extend credit?How high must the credit price be to make it worthwhile for the firm to extend credit?
The NPV of Net 30 must be at least as big as the NPV of cash only:
365/30
'0
)10.1(
95.0300,1425$300,1000,100$
P
95.0300,1)10.1()425$300,1000,100($ '0
365/30 P
50.532$95.0300,1
)10.1()425$300,1000,100($ 365/30'
0
P
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The Value of New Informationabout Credit Risk
The most that we should be willing to pay for new information about credit risk is the present value of the expected cost of defaults:
The most that we should be willing to pay for new information about credit risk is the present value of the expected cost of defaults: $0
(1 + rB) –C0 × Q0
′′ +NPV default = × (1 – h)
–C0 × Q0′′NPV default = × (1 – h)
C0 × Q0′′ × (1 – h) = $425×1,300×(1 – 0.95) = $27,625
In our earlier example, with a credit price of $500, we would be willing to pay $27,625 for a perfect credit screen.
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Future Sales and the Credit Decision
Customer pays h = 100%
Customer pays (Probability = h)
Customer defaults(Probability = 1– h)
Our first decision:
We refuse further sales to deadbeats.
Information is revealed at the end of the first period:
We face a more certain credit decision with our paying customers:
Give credit
Do not give credit
Do not give credit
Give credit
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28.3 Optimal Credit Policy
Carrying Costs
Total costs
C*
Costs in dollars
Level of credit extended
At the optimal amount of credit, the incremental cash flows from increased sales are exactly equal to the carrying costs from the increase in accounts receivable.
Opportunity costs
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28.3 Optimal Credit Policy
Trade Credit is more likely to be granted if:1. The selling firm has a cost advantage over other lenders.
2. The selling firm can engage in price discrimination.
3. The selling firm can obtain favorable tax treatment.
4. The selling firm has no established reputation for quality products or services.
5. The selling firm perceives a long-term strategic relationship.
The optimal credit policy depends on the characteristics of particular firms.
Trade Credit is more likely to be granted if:1. The selling firm has a cost advantage over other lenders.
2. The selling firm can engage in price discrimination.
3. The selling firm can obtain favorable tax treatment.
4. The selling firm has no established reputation for quality products or services.
5. The selling firm perceives a long-term strategic relationship.
The optimal credit policy depends on the characteristics of particular firms.
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28.4 Credit Analysis
Credit InformationFinancial StatementsCredit Reports on Customer’s PaymentHistory with Other FirmsBanksCustomer’s Payment History with the Firm
Credit InformationFinancial StatementsCredit Reports on Customer’s PaymentHistory with Other FirmsBanksCustomer’s Payment History with the Firm
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28.4 Credit Analysis
Credit Scoring: The traditional 5 C’s of credit
CharacterCapacityCapital CollateralConditions
Some firms employ sophisticated statistical models
Credit Scoring: The traditional 5 C’s of credit
CharacterCapacityCapital CollateralConditions
Some firms employ sophisticated statistical models
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28.5 Collection Policy
Collection refers to obtaining payment on past-due accounts.Collection Policy is composed of
The firm’s willingness to extend credit as reflectedin the firm’s investment in receivables.Collection Effort
Collection refers to obtaining payment on past-due accounts.Collection Policy is composed of
The firm’s willingness to extend credit as reflectedin the firm’s investment in receivables.Collection Effort
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Average Collection Period
Measures the average amount of time required to collect an account receivable. Measures the average amount of time required to collect an account receivable.
For example, a firm with average daily sales of $20,000 and an investment in accounts receivable of $150,000 has an average collection period of
Average Collection Period =Accounts receivableAverage daily sales
7.5 days =$150,000
$20,000/day
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Accounts Receivable Aging Schedule
Shows receivables by age of account.
The longer an account has been unpaid, the less likely it is to be paid.
Shows receivables by age of account.
The longer an account has been unpaid, the less likely it is to be paid.
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Collection Effort
Most firms follow a protocol for customers that are past due:1. Send a delinquency letter.
2. Make a telephone call to the customer.
3. Employ a collection agency.
4. Take legal action against the customer.
Most firms follow a protocol for customers that are past due:1. Send a delinquency letter.
2. Make a telephone call to the customer.
3. Employ a collection agency.
4. Take legal action against the customer.
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Collection Effort
There is a potential for a conflict of interest between the collections department and the sales department.
You need to strike a balance between antagonizing a customer and being taken advantage of by a deadbeat.
There is a potential for a conflict of interest between the collections department and the sales department.
You need to strike a balance between antagonizing a customer and being taken advantage of by a deadbeat.
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Factoring
The sale of a firm’s accounts receivable to a financial institution (known as a factor).The firm and the factor agree on the basic credit terms for each customer.
The sale of a firm’s accounts receivable to a financial institution (known as a factor).The firm and the factor agree on the basic credit terms for each customer.
Firm
Factor
Customer
Customers send payment to the factor
The factor pays an agreed-upon percentage of the
accounts receivable to the firm. The factor bears the
risk of nonpaying customers
Goods
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28.6 How to Finance Trade Credit
There are three general ways of financing accounting receivables:
1. Secured Debt– Referred to as asset-based receivables financing.– The predominant form of receivables financing.
2. Captive Finance Company– Large companies with good credit ratings often form a finance
company as a subsidiary of the firm.
3. Securitization– Occurs when the selling firm sells its accounts receivable to a
financial institution, which then pools the receivables and sells securities backed by these assets.
There are three general ways of financing accounting receivables:
1. Secured Debt– Referred to as asset-based receivables financing.– The predominant form of receivables financing.
2. Captive Finance Company– Large companies with good credit ratings often form a finance
company as a subsidiary of the firm.
3. Securitization– Occurs when the selling firm sells its accounts receivable to a
financial institution, which then pools the receivables and sells securities backed by these assets.
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28.7 Summary & Conclusions
1. The components of a firm’s credit policy are the terms of sale, the credit analysis, and the collection policy.
2. The decision to grant credit is a straightforward NPV problem.
3. Additional information about the probability of customer default has value, but must be weighed against the cost of the information.
4. The optimal amount of credit is a function of the conditions in which a firm finds itself.
5. The collection policy is the firm’s method for dealing with past-due accounts—it is an integral part of the decision to extend credit.
1. The components of a firm’s credit policy are the terms of sale, the credit analysis, and the collection policy.
2. The decision to grant credit is a straightforward NPV problem.
3. Additional information about the probability of customer default has value, but must be weighed against the cost of the information.
4. The optimal amount of credit is a function of the conditions in which a firm finds itself.
5. The collection policy is the firm’s method for dealing with past-due accounts—it is an integral part of the decision to extend credit.
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