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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides edited by HD Quan

21-1

Week 15 - Chapter Twenty One

Credit & Inventory Management

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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 Policy21.6 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

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21-3

Chapter Objectives

Understand the components of credit policy and thecash flows associated with granting credit.

Identify the factors that influence the length of thecredit period.

Calculate the cost of forgoing discounts in creditperiods.

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

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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides 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

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21-5

Creditsale ismade

Customermails

cheque

Firm depositscheque in

bank

Bank creditsfirms

account

Cash collection

Accounts receivable

Time

Cash Flows from Granting Credit

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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 instrumentEvidence of indebtedness such as an invoice or

promissory note.

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21-7

Length of the Credit Period

Factors that influence the length of the credit periodinclude:

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.

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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a

Fundamentals of Corporate Finance3eRoss, Thompson, Christensen, Westerfield and Jordan

Slides prepared by Sue Wright & edited by HD Quan21-8

Cost of the Credit

2/10, net 30 = buyer pays in 10 days to get a 2 percent discount, or within 30 days for no discount.

Buyer has an order for $1500 and ignores thecredit period gives up $30 discount.

The benefit obviously lies in paying early.

44.59%14701

301EAR

20365

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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and Jordan


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 itsells on credit.

The cash discountDiscounts induce buyers to pay early;the size of the discount affects payment patterns andamounts.

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Evaluating a Proposed Credit Policy

P= price per unit Q= new quantity expected to be soldv = variable cost per unit Q = current quantity sold per period

R = periodic required return

The benefitof switching is the change in cash flow:

QQ'vP

QvPQ'vP

grearrangin

flowcasholdflowcashNew

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Evaluating a Proposed Credit Policy

Thepresent value of switching is:

PV = [(Pv) (QQ)]/R

The costof switching is the amount uncollected for

the period plus the additional variable costs ofproduction:

Cost =PQ + v(QQ)

And the NPVof the switch is:NPV =[PQ + v(QQ)] + [(Pv)(QQ)]/R

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ExampleEvaluating a Proposed

Credit Policy

ABC Co. is thinking of changing from a cash-onlypolicy to a net 30 days on sales policy. The

company has estimated the following:

P = $55 v= $32 Q = 160

Q= 175 R= 2%

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SolutionEvaluating a Proposed

Credit Policy

4025$

1753255

policy)(newflowCash3680$

1603255

policy)(oldflowCash

Q'vP

QvP

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Credit Policy

25017$020

345

switchingofPV

345$

1601753255

switchingofBenefit

.

R

QQ'vP

QQ'vP

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Credit Policy

8930$

250178320

switchingofNPV

8320$

1601753216055

switchingofCost

/RQQ'vPQQ'vPQ

QQ'vPQ

Therefore, the switch is very profitable.

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Break-even Point

units877

320203255

16055

.

./

v/RvP

PQQQ'

The switch is a good idea as long as thecompany can sell an additional 7.87 units.

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Discounts and Default Risk

ABC Co. currently has a cash price of $55 per unit. If thecompany extends the 30 day credit policy, the price willincrease to $56 per unit on credit sales. ABC Co. expects 0.5per cent of credit to go uncollected (). All other informationremains unchanged. Should the company switch to the credit

policy?

%.

d

79156$

55$56$

customerscashforalloweddiscountPercentage

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Discounts and Default Risk

803020$

02000500179016056$16055$

NPV

.

./..

/RdQP'PQ

NPV of changing credit terms:

As the NPV of the change is negative, ABC Co.should not switch.

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The Costs of Granting Credit

Opportunity costs are lost sales from refusingcredit. These costs go down when credit isgranted.

Carrying costs are the cash flows that must be

incurred when credit is granted. They arepositively related to the amount of credit extended.

The required return on receivables.

The losses from bad debts.

The costs of managing credit and creditcollections.

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Optimal Credit Policy

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Credit Analysis

Process of deciding which customers receivecredit.

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 longas variable cost is low relative to price (highmarkup).

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Collection Policy

Monitoring receivables:

- Keep an eye on average collection period relative to yourcredit terms.

Ageing schedulecompilation of accounts receivable by theage 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.

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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.

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Inventory Management

Inventory Types

a) Raw Material

b) Work-in-progress

c) Finished goods

Inventory Costs:

Carrying CostsStorage and tracking costs

Insurance and Taxes

Obsolescence, deterioration and theft

Opportunity cost of capital on the invested amount

- Shortage CostsInadequate inventory on hand restocking cost/safety reserves

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ABC Approach divide into 3 groups

A) 10% of by item count 50% value

B) in between

C) Crucial parts but inexpensive Low Value

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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

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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and Jordan 21-27


JIT (Just In Time) Inventory/System:

Developed in Japan By Toyota in 1948 1975 (Toyota ProductionSystem) (Sakichi Toyoda and son Kiichiro Toyoda & Taiichi Ohno)

Goal is to have ONLY enough inventory on hand to meet immediateproduction needs

Keiretsu network of suppliers, high degree of cooperation

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

management.

Documents

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