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Trade Credit and Receivables

A firm offers terms of 2/15, net 30. Currently, two-thirds of all customers take advantage of the trade discount; the remainder pay bills at the due date.

a. What will be the firm`s typical value for its accounts receivable period?

b. What is the average investment in accounts receivable if annual sales are $20 million?

c. What would likely happen to the firm`s accounts receivable period if it changed its terms to 3/15, net 30?

8. Terms of Sale. Microbiotics currently sells all of its frozen dinners cash on delivery but believes it can increase sales by offering supermarkets 1 month of free credit. The price per carton is $50 and the cost per carton is $40.

a. If unit sales will increase from 1,000 cartons to 1,060 per month, should the firm offer the credit? The interest rate is 1 percent per month, and all customers will pay their bills.

b. What if the interest rate is 1.5 percent per month?

c. What if the interest rate is 1.5 percent per month, but the firm can offer the credit only as a special deal to new customers, while old customers will continue to pay cash on delivery?

9. Credit Decision/Repeat Sales. Locust Software sells computer training packages to its business customers at a price of $101. The cost of production (in present value terms) is $95. Locust sells its packages on terms of net 30 and estimates that about 7 percent of all orders will be uncollectible. An order comes in for 20 units. The interest rate is 1 percent per month. a. Should the firm extend credit if this is a one-time order? The sale will not be made unless credit is extended.

b. What is the break-even probability of collection?

c. Now suppose that if a customer pays this month`s bill, it will place an identical order in each month indefinitely and can be safely assumed to pose no risk of default. Should credit be extended?

d. What is the break-even probability of collection in the repeat-sales case?

10. Bankruptcy. Explain why equity can sometimes have a positive value even when companies petition for bankruptcy.

11. Credit Decision. Look back at Example 3. Cast Iron`s costs have increased from $1,000 to $1,050. Assuming there is no possibility of repeat orders, and that the probability of successful collection from the customer is p = .9, answer the following:

a. Should Cast Iron grant or refuse credit?

b. What is the break-even probability of collection?

12. Credit Analysis. Financial ratios were described earlier. If you were the credit manager, to which financial ratios would you pay most attention?

13. Credit Decision. The Branding Iron Company sells its irons for $50 apiece wholesale. Production cost is $40 per iron. There is a 25 percent chance that a prospective customer will go bankrupt within the next half year. The customer orders 1,000 irons and asks for 6 months` credit. Should you accept the order? Assume a 10 percent per year discount rate, no chance of a repeat order, and that the customer will pay either in full or not at all.

14. Credit Policy. As treasurer of the Universal Bed Corporation, Aristotle Procrustes is worried about his bad debt ratio, which is currently running at 6 percent. He believes that imposing a more stringent credit policy might reduce sales by 5 percent and reduce the bad debt ratio to 4 percent. If the cost of goods sold is 80 percent of the selling price, should Mr. Procrustes adopt the more stringent policy?

15. Credit Decision/Repeat Sales. Surf City sells its network browsing software for $15 per copy to computer software distributors and allows its customers 1 month to pay their bills.The cost of the software is $10 per copy. The industry is very new and unsettled, however, and the probability that a new customer granted credit will go bankrupt within the next month is 25 percent. The firm is considering switching to a cash- on-delivery credit policy to reduce its exposure to defaults on trade credit. The discount rate is 1 percent per month.

a. Should the firm switch to a cash-on-delivery policy? If it does so, its sales will fall by 40 percent.

b. How would your answer change if a customer which is granted credit and pays its bills can be expected to generate repeat orders with negligible likelihood of default for each of the next 6 months? Similarly, customers which pay cash also will generate on average 6 months of repeat sales.

16. Credit Policy. A firm currently makes only cash sales. It estimates that allowing trade credit on terms of net 30 would increase monthly sales from 200 to 220 units per month. The price per unit is $101 and the cost (in present value terms) is $80. The interest rate is 1 percent per month.

a. Should the firm change its credit policy?

b. Would your answer to (a) change if 5 percent of all customers will fail to pay their bills under the new credit policy?

c. What if 5 percent of only the new customers fail to pay their bills? The current customers take advantage of the 30 days of free credit but remain safe credit risks.