Chapter 6 Credit Policy and Collections Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection < Inventory > < Receivable > < Float > Time ==> Accounts Disbursement < Payable > < Float > Invoice Received Payment Sent Cash Disbursed

Evaluate Changes in Credit Policy Credit term change decision variables effect on dollar profits sales effect receivables effect return on investment effect 84% can estimate: default probability credit limits opportunity cost of funds invested in receivables company’s overall cost of capital

Changing Credit Terms, EQ 6.1 (P. 196) NPV Average Daily Sales = PV of Sales to discount-takers + PV of Sales to non-discount takers - Variable Operating Costs - PV of Variable Credit and Collection Costs

Changing Credit Terms, Equation 6.1 ZN = [(1+g)SE](1-dN)PN(1-bN) / (1 + iDPN) PV discount payments + [(1+g)SE](1-PN)(1-bN) / (1 + iCPN) PV non-discount pmts - VCR [(1+g)SE] PV variable cost pmts - [EXPN[(1+g)SE] / (1 + iCPN) PV credit expense pmts

Existing Credit Terms, Equation 6.2 ZE = SE(1-dE)PE(1-bE) / (1 + iDPE) PV discount pmts + SE(1-PE)(1-bE) / (1 + iCPE) PV non-discount pmts - VCR (SE) PV variable cost pmts EXPE SE / (1 + iCPE) PV credit expense pmts (correct this in your textbook)

Changing Credit Terms, Equation 6.3, 6.4 Equation 6.3 Z = ZN - ZE Decision Rule: IF Z > 0 then Accept policy change IF Z = 0 then Indifferent IF Z < 0 then Reject policy change Equation 6.4 NPV = Z / i

Assignment AJ Group’s CEO Mr. Ananta Jalil asked you make a recommendation to the executive policy committee on whether the company should tighten its credit standards. The marketing department estimates that annual sales will drop by BDT 15 million from the present level of BDT 200 million. The VCR is 0.60 and it will not change, and the credit and collection expenses will increase from 1.25 percent to 1.50 percent under the proposal. The bad debt expense rate on both existing and incremental sales is estimated to be 10 percent. The DSO of 30 days is not expected to change. The company’s annual cost of capital is 18 percent. a. Calculate the decision’s 1-day change in value. b. Calculate the decision’s NPV. c. Do you recommend tightening the credit standards? Explain.

Monitoring Collections

Spreadsheet containing sales and A/C receivable data

Aging Schedule

Monitoring Collections Receivables turnover least favored technique Days sales outstanding, DSO ranked almost as high as aging schedules Aging schedules ranked as most favored technique

Problem All three traditional measures have a serious flaw All three are influenced by sales trends Choice of averaging period impact turnover and DSO Increasing sales tends to: improve aging schedules worsen DSO and A/C Receivable turnover

Solution: Uncollected balance percentage/ Payment pattern approach

Collection Procedures Typical collection effort initial contact within 10 days of delinquency then reminder letter followed by phone call sales force notified last resort, reference to collection agency/legal action Collection agency Phase 1 - computer generated collection letter, when accounts are 45 to 90 days past due Phase 2 - commissioned collectors used Companies tend to be more aggressive the larger the receivables balance Companies understand the good-will tradeoff when selecting collection methods