Corporate Finance Ross  Westerfield  Jaffe Seventh Edition 28 Chapter Twenty Eight Credit Management Corporate Finance Ross  Westerfield  Jaffe Seventh Edition

Chapter Outline 28.1 Terms of the Sale 28.2 The Decision to Grant Credit: Risk and Information 28.3 Optimal Credit Policy 28.4 Credit Analysis 28.5 Collection Policy 28.6 How to Finance Trade Credit 28.7 Summary & Conclusions

Introduction A firm’s 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 firm’s account Time Cash collection Accounts receivable

28.1 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 A jewelry store might have terms 5/30 net 4 months; a lumber yard 3/10 net 30; a fruit wholesaler net 7.

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. 10 30 $970 Other customers will pay on day 30 and forgo the discount. 10 30 $1,000

The Interest Rate Implicit in 3/10 net 30 A customer that forgoes the 3% discount to pay on day 30 is borrowing $970 for 20 days and paying $30 interest: 10 30 +$970 –$1,000

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 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.

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) The superscript primes indicate that costs, quantities and prices may be different under cash and credit policies. Some students might claim that a better notation would be to use subscripts of 1 for period 1 cash flows—I think our textbook authors see that the quantities and prices were set at time 0 even though they occur at time 1 and want to avoid confusion when there are sales in subsequent periods. Consider a steady state for a retailer with ongoing operations. At time 0 he sells Q0 and at time 1 he gets paid for that and sells Q1.

28.2 The Decision to Grant Credit: Risk and Information The expected cash flows of the credit strategy are: We incur costs up front… –C0 × Q0 ′ h × Q0 × P0 ′ 1 …and get paid in 1 period by h% of our customers. The superscript primes indicate that costs, quantities and prices may be different under cash and credit policies. Some students might claim that a better notation would be to use subscripts of 1 for period 1 cash flows—I think our textbook authors see that the quantities and prices were set at time 0 even though they occur at time 1 and want to avoid confusion when there are sales in subsequent periods. Consider a steady state for a retailer with ongoing operations. At time 0 he sells Q0 and at time 1 he gets paid for that and sells Q1.

28.2 The Decision to Grant Credit: Risk and Information The NPV of the cash only strategy is: NPVcash = Q0 × (P0 – C0) The NPV of the credit strategy is: h × Q0 × P0 ′ (1 + rB) –C0 × Q0 + NPVcredit = The delayed revenues from granting credit: The immediate costs of granting credit: The probability of repayment: h The discount rate: rB P0 × Q0 ′ C0 × Q0 The decision to grant credit depends on four factors:

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   No Credit Net 30 Quantity sold 1,000 1,300 Selling price $500 Unit cost $400 $425 Probability of payment 100% 95% Credit period (days) 30 Discount rate per annum 10% The NPV of cash only = 1,000×($500 – $400) = $100,000 The NPV of Net 30: 1,300×$500×0.95 –1,300×$425 + (1.10)30/365 = $60,181.58

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: $0 (1 + rB) –C0 × Q0 ′ + NPV default = × (1 – h) –C0 × Q0 ′ NPV default = × (1 – h) In our earlier example, with a credit price of $500, we would be willing to pay $27,625 for a perfect credit screen. C0 × Q0 ′ × (1 – h) = $425×1,300×(1 – 0.95) = $27,625

Future Sales and the Credit Decision Customer pays h = 100% We face a more certain credit decision with our paying customers: Do not give credit Give credit Information is revealed at the end of the first period: Customer pays (Probability = h) Give credit Do not give credit Customer defaults (Probability = 1– h) We refuse further sales to deadbeats. Our first decision:

28.3 Optimal Credit Policy Costs in dollars Total costs Carrying Costs Opportunity costs Total costs Carrying Costs Carrying costs are the costs that must be incurred when credit is granted. Opportunity costs are the lost sales from refusing credit. Level of credit extended C* 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.

28.3 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. The selling firm can obtain favorable tax treatment. The selling firm has no established reputation for quality products or services. The selling firm perceives a long-term strategic relationship. The optimal credit policy depends on the characteristics of particular firms.

28.4 Credit Analysis Credit Information Financial Statements Credit Reports on Customer’s Payment History with Other Firms Banks Customer’s Payment History with the Firm

28.4 Credit Analysis Credit Scoring: The traditional 5 C’s of credit Character Capacity Capital Collateral Conditions Some firms employ sophisticated statistical models

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 reflected in the firm’s investment in receivables. Collection Effort

Average Collection Period Measures the average amount of time required to collect an account receivable. Average Collection Period = Accounts receivable Average daily sales 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 7.5 days = $150,000 $20,000/day

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.

Collection Effort Most firms follow a protocol for customers that are past due: Send a delinquency letter. Make a telephone call to the customer. Employ a collection agency. Take legal action against the customer.

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.

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 factor pays an agreed-upon percentage of the accounts receivable to the firm. The factor bears the risk of nonpaying customers Customers send payment to the factor Factor Customer Firm Goods

28.6 How to Finance Trade Credit There are three general ways of financing accounting receivables: Secured Debt Referred to as asset-based receivables financing. The predominant form of receivables financing. Captive Finance Company Large companies with good credit ratings often form a finance company as a subsidiary of the firm. 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.

28.7 Summary & Conclusions The components of a firm’s credit policy are the terms of sale, the credit analysis, and the collection policy. The decision to grant credit is a straightforward NPV problem. Additional information about the probability of customer default has value, but must be weighed against the cost of the information. The optimal amount of credit is a function of the conditions in which a firm finds itself. 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.