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Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,McGraw-Hill/Irwin,Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.,Click here for title,29-,0,Chapter Outline,29.1,Terms of the Sale,29.2 The Decision to Grant Credit:,Risk and Information,29.3 Optimal Credit Policy,29.4 Credit Analysis,29.5 Collection Policy,29.6 How to Finance Trade Credit,29.7 Summary&Conclusions,Introduction,A firms credit policy is composed of:,Terms of the sale,Credit analysis,Collection policy,This chapter discusses each of the components of credit policy that makes up the decision to grant credit.,The Cash Flows of Granting Credit,Credit sale is made,Customer mails check,Firm deposits check,Bank credits firms account,Accounts receivable,Cash collection,Time,29.1,Terms of the Sale,The terms of sale of composed of,Credit Period,Cash Discounts,Credit Instruments,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,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.,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,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,$1,000,0,10,30,+$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,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 goods,Commercial drafts,call for a customer to pay a specific amount by a specific date.The draft is sent to the customers bank,when the customer signs the draft,the goods are sent.,Bankers 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.,29.2,The Decision to Grant Credit:Risk and Information,Consider a firm that is choosing between two alternative credit policies:,“In God we trusteverybody else pays cash.”,Offering their customers credit.,The only cash flow of the first strategy is,The,expected,cash flows of the credit strategy are:,0,1,We incur costs up front,and get paid in 1 period by,h,%of our customers.,29.2,The Decision to Grant Credit:Risk and Information,The NPV of the cash only strategy is,The NPV of the credit strategy is,The decision to grant credit depends on four factors:,The delayed revenues from granting credit,The immediate costs of granting credit,The probability of repayment,h,The discount rate,r,B,Example of the Decision to Grant 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.,Example of the Decision to Grant Credit,The NPV of cash only:,The NPV of Net 30:,Example of the Decision to Grant 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:,The Value of New Information about 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:,In our earlier example,with a credit price of$500,we would be willing to pay$26,000 for a,perfect,credit screen.,Future Sales and the Credit Decision,Do not give credit,Give credit,Customer pays,h=,100%,Customer pays(Probability=,h,),Customer defaults,(,Probability=1,h,),Give credit,Do not give credit,Our first decision:,We refuse further sales to deadbeats.,We face a more certain credit decision with our,paying,customers:,Information is revealed at the end of the first period:,29.3,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,29.3,Optimal Credit Policy,Trade Credit is more likely to be granted if:,The selling firm has a cost advantage over other lenders.,The selling firm can engage in price discrimination.,
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