Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Fundamentals of Corporate Finance 3e

Ross, Thompson, Christensen, Westerfield and Jordan
Slides edited by HD Quan
21-1
Week 15 - Chapter Twenty One

Credit & Inventory Management
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides edited by HD Quan
21-2
21.1 Credit and Receivables
21.2 Terms of the Sale
21.3 Analyzing Credit Policy
21.4 More on Credit Policy Analysis
21.5 Optimal Credit Policy
21.6 Credit Analysis
21.7 Collection Policy
21.8 Five Cs
21.9 Inventory Costs
21.10 Inventory Alphabet Soup ABC, EOQ, JIT
21.11 Summary and Conclusions
Chapter Organization
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides edited by HD Quan
21-3
Chapter Objectives
Understand the components of credit policy and the
cash flows associated with granting credit.
Identify the factors that influence the length of the
credit period.
Calculate the cost of forgoing discounts in credit
periods.
Outline the various credit policy effects.
Calculate the cost and NPV of switching policies.
Determine the optimal credit policy.
Discuss the five Cs of credit.
Discuss Inventory Management ABC, EOQ, JIT
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-4
Components of Credit Policy
Terms of sale
The conditions on which a firm sells its goods and services
for cash or credit.
Credit analysis
The process of determining the probability that customers will
not pay.
Collection policy
Procedures that are followed by a firm in collecting accounts
receivable.

Accounts receivable = Average daily sales average
collection period
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-5
Credit
sale is
made
Customer
mails
cheque
Firm deposits
cheque in
bank
Bank credits
firms
account
Cash collection
Accounts receivable
Time
Cash Flows from Granting Credit
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-6
Terms of the Sale
Credit period
The length of time that credit is granted, usually
between 30 and 120 days.

Cash discount
A discount that is given for a cash purchase to speed
up the collection of receivables.

Credit instrument
Evidence of indebtedness such as an invoice or
promissory note.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-7
Length of the Credit Period
Factors that influence the length of the credit period
include:
buyers inventory period and operating cycle
perishability and collateral value of goods
consumer demand for the product
cost, profitability and standardization
credit risk of the buyer
the size of the account
competition in the product market
customer type.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-8
Cost of the Credit
2/10, net 30 = buyer pays in 10 days to get a 2 per
cent discount, or within 30 days for no discount.
Buyer has an order for $1500 and ignores the
credit period gives up $30 discount.





The benefit obviously lies in paying early.
44.59% 1
470 1
30
1 EAR
20
365
=
|
.
|

\
|
+ =
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-9
Credit Policy Effects
Revenue effectsPayment is received later, but price and
quantity sold may increase.
Cost effectsCost of sale is still incurred even though the
cash from the sale has not been received.
The cost of debtThe firm must finance receivables and,
therefore, incur financing costs.
The probability of non-paymentThe firm always gets paid if
it sells for cash, but risks losses due to customer default if it
sells on credit.
The cash discountDiscounts induce buyers to pay early;
the size of the discount affects payment patterns and
amounts.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-10
Evaluating a Proposed Credit Policy
P = price per unit Q = new quantity expected to be sold
v = variable cost per unit Q = current quantity sold per period
R = periodic required return
The benefit of switching is the change in cash flow:

( ) | | ( ) | |
( ) ( ) Q Q' v P
Q v P Q' v P




g rearrangin
flow cash old flow cash New
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-11
Evaluating a Proposed Credit Policy
The present value of switching is:
PV = [(P v) (Q Q)]/R

The cost of switching is the amount uncollected for
the period plus the additional variable costs of
production:
Cost = PQ + v(Q Q)

And the NPV of the switch is:
NPV = [PQ + v(Q Q)] + [(P v)(Q Q)]/R
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-12
ExampleEvaluating a Proposed
Credit Policy
ABC Co. is thinking of changing from a cash-only
policy to a net 30 days on sales policy. The
company has estimated the following:

P = $55 v = $32 Q = 160

Q = 175 R = 2%
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-13
SolutionEvaluating a Proposed
Credit Policy
( )
( )
( )
( )
4025 $
175 32 55
policy) (new flow Cash
3680 $
160 32 55
policy) (old flow Cash


Q' v P


Q v P
=
=
=
=
=
=
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-14
SolutionEvaluating a Proposed
Credit Policy
( ) ( )
( ) ( )
( ) ( ) | |
250 17 $
02 0
345
switching of PV
345 $
160 175 32 55
switching of Benefit

.
R
Q Q' v P



Q Q' v P
=
=

=
=
=
=
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-15
SolutionEvaluating a Proposed
Credit Policy
( )
( ) ( )
( ) | | ( )( )
8930 $
250 17 8320
switching of NPV
8320 $
160 175 32 160 55
switching of Cost


/R Q Q' v P Q Q' v PQ


Q Q' v PQ
=
+ =
+ + =
=
+ =
+ =
Therefore, the switch is very profitable.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-16
Break-even Point
( )
( ) | |
( )
( ) | |
units 87 7
32 02 0 32 55
160 55
.
. /


v /R v P
PQ
Q Q'
=


=

=
The switch is a good idea as long as the
company can sell an additional 7.87 units.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-17
Discounts and Default Risk
ABC Co. currently has a cash price of $55 per unit. If the
company extends the 30 day credit policy, the price will
increase to $56 per unit on credit sales. ABC Co. expects 0.5
per cent of credit to go uncollected (t). All other information
remains unchanged. Should the company switch to the credit
policy?
( )
( )
% .
d
79 1
56 $
55 $ 56 $
customers cash for allowed discount Percentage
=

=
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-18
Discounts and Default Risk
( )
( )
80 3020 $
02 0 005 0 0179 0 160 56 $ 160 55 $
NPV
.
. / . .
/R d Q P' PQ
=
+ =
t + =
NPV of changing credit terms:
As the NPV of the change is negative, ABC Co.
should not switch.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-19
The Costs of Granting Credit
Opportunity costs are lost sales from refusing
credit. These costs go down when credit is
granted.
Carrying costs are the cash flows that must be
incurred when credit is granted. They are
positively related to the amount of credit extended.
The required return on receivables.
The losses from bad debts.
The costs of managing credit and credit
collections.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-20
Optimal Credit Policy
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-21
Credit Analysis
Process of deciding which customers receive
credit.

One-time salerisk is variable cost only.

Repeat customersbenefit is gained from one-
time sale in perpetuity.

Grant credit to almost all customers once as long
as variable cost is low relative to price (high
markup).
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-22
Collection Policy
Monitoring receivables:
- Keep an eye on average collection period relative to your
credit terms.

Ageing schedulecompilation of accounts receivable by the
age of each account; used to determine the percentage of
payments that are being made late.

Collection procedures include:
delinquency letters
telephone calls
employment of collection agency
legal action.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-23
Summary: The Five Cs of Credit
There is NO magical formulas to determine the probability
that a customer will not PAY.so remember the Five Cs!
Character
Customers willingness to pay.
Capacity
Customers ability to pay.
Capital
Financial reserves/borrowing capacity.
Collateral
Pledged assets.
Conditions
Relevant economic conditions.
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-24
Inventory Management
Inventory Types
a) Raw Material
b) Work-in-progress
c) Finished goods
Inventory Costs:
Carrying Costs
Storage and tracking costs
Insurance and Taxes
Obsolescence, deterioration and theft
Opportunity cost of capital on the invested amount
- Shortage Costs
Inadequate inventory on hand restocking cost/safety reserves
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-25
Inventory Management
ABC Approach divide into 3 groups

A) 10% of by item count 50% value

B) in between

C) Crucial parts but inexpensive Low Value
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-26
Inventory Management
EOQ (Economic Order Quantity ) Model:
Total Inventory Cost Curve
Explicitly establish an Optimal Inventory Level
Plots various costs associated with holding inventory (x-axis)
Against inventory level (y-axis)

Goal is to attempt to find Optimal size of Inventory Order.
Minimum total cost point !

* determine what order size the firm should use when it restock
inventory


Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright & edited by HD Quan
21-27
Inventory Management
JIT (Just In Time) Inventory/System:
Developed in Japan By Toyota in 1948 1975 (Toyota Production
System) (Sakichi Toyoda and son Kiichiro Toyoda & Taiichi Ohno)

Goal is to have ONLY enough inventory on hand to meet immediate
production needs

Keiretsu network of suppliers, high degree of cooperation

JIT is an important part of a larger production planning process. It shift
focus away from finance and into manufacturing and production
management.