28-1

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

CHAPTER

28Credit

Management

28-2

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

28-3

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-4

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-5

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-6

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-7

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-8

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-9

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-10

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-11

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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)

28-12

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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′′

28-13

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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:

28-14

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-15

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-16

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-17

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-18

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-19

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-20

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-21

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-22

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-23

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-24

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-25

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-26

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-27

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-28

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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

28-29

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.

28-30

McGraw-Hill/IrwinCorporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights

Reserved.

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.