ChapterOutline29.1TermsoftheSale29.2TheDecisiontoGrantCredit:RiskandInformation29.3OptimalCreditPolicy29.4CreditAnalysis29.5CollectionPolicy29.6HowtoFinanceTradeCredit29.7Summary&ConclusionsChapterOutline29.1TermsoftIntroductionAfirm’screditpolicyiscomposedof:TermsofthesaleCreditanalysisCollectionpolicyThischapterdiscusseseachofthecomponentsofcreditpolicythatmakesupthedecisiontograntcredit.IntroductionAfirm’screditpoTheCashFlowsofGrantingCreditCreditsaleismadeCustomermailscheckFirmdepositscheckBankcreditsfirm’saccountAccountsreceivableCashcollectionTimeTheCashFlowsofGrantingCre29.1TermsoftheSaleThetermsofsaleofcomposedofCreditPeriodCashDiscountsCreditInstruments29.1TermsoftheSaleThetermCreditPeriodCreditperiodsvaryacrossindustries.Generallyafirmmustconsiderthreefactorsinsettingacreditperiod:Theprobabilitythatthecustomerwillnotpay.Thesizeoftheaccount.Theextenttowhichgoodsareperishable.LengtheningthecreditperiodgenerallyincreasessalesCreditPeriodCreditperiodsvaCashDiscountsOftenpartofthetermsofsale.Tradeoffbetweenthesizeofthediscountandtheincreasedspeedandrateofcollectionofreceivables.Anexamplewouldbe“3/10net30”Thecustomercantakea3%discountifhepayswithin10days.Inanyevent,hemustpaywithin30days.CashDiscountsOftenpartofthTheInterestRateImplicitin3/10net30Afirmofferingcredittermsof3/10net30isessentiallyofferingtheircustomersa20-dayloan.Toseethis,considerafirmthatmakesa$1,000saleonday0Somecustomerswillpayonday10andtakethediscount.Othercustomerswillpayonday30andforgothediscount.01030$97001030$1,000TheInterestRateImplicitin01030+$970-$1,000Acustomerthatforgoesthe3%discounttopayonday30isborrowing$970for20daysandpaying$30interest:TheInterestRateImplicitin3/10net3001030+$970-$1,000AcustomerthCreditInstrumentsMostcreditisofferedonopenaccount—theinvoiceistheonlycreditinstrument.PromissorynotesareIOUsthataresignedafterthedeliveryofgoodsCommercialdraftscallforacustomertopayaspecificamountbyaspecificdate.Thedraftissenttothecustomer’sbank,whenthecustomersignsthedraft,thegoodsaresent.Banker’sacceptancesallowabanktosubstituteitscreditworthinessforthecustomer,forafee.Conditionalsalescontractsletthesellerretainlegalownershipofthegoodsuntilthecustomerhascompletedpayment.CreditInstrumentsMostcredit29.2TheDecisiontoGrantCredit:RiskandInformationConsiderafirmthatischoosingbetweentwoalternativecreditpolicies:“InGodwetrust—everybodyelsepayscash.”O(jiān)fferingtheircustomerscredit.

Theonlycashflowofthefirststrategyis

Theexpectedcashflowsofthecreditstrategyare:01Weincurcostsupfront……andgetpaidin1periodbyh%ofourcustomers.29.2TheDecisiontoGrantCre29.2TheDecisiontoGrantCredit:RiskandInformationTheNPVofthecashonlystrategyisTheNPVofthecreditstrategyisThedecisiontograntcreditdependsonfourfactors:Thedelayedrevenuesfromgrantingcredit,Theimmediatecostsofgrantingcredit,Theprobabilityofrepayment,hThediscountrate,rB29.2TheDecisiontoGrantCreExampleoftheDecisiontoGrantCreditAfirmcurrentlysells1,000itemspermonthonacashbasisfor$500each.Iftheyofferedtermsnet30,themarketingdepartmentbelievesthattheycouldsell1,300itemspermonth.Thecollectionsdepartmentestimatesthat5%ofcreditcustomerswilldefault.Thecostofcapitalis10%perannum.ExampleoftheDecisiontoGraExampleoftheDecisiontoGrantCreditTheNPVofcashonly:TheNPVofNet30:ExampleoftheDecisiontoGraExampleoftheDecisiontoGrantCreditHowhighmustthecreditpricebetomakeitworthwhileforthefirmtoextendcredit?TheNPVofNet30mustbeatleastasbigastheNPVofcashonly:ExampleoftheDecisiontoGraTheValueofNewInformationaboutCreditRiskThemostthatweshouldbewillingtopayfornewinformationaboutcreditriskisthepresentvalueoftheexpectedcostofdefaults:Inourearlierexample,withacreditpriceof$500,wewouldbewillingtopay$26,000foraperfectcreditscreen.TheValueofNewInformationaFutureSalesandtheCreditDecisionDonotgivecreditGivecreditCustomerpaysh=100%Customerpays(Probability=h)Customerdefaults(Probability=1–h)GivecreditDonotgivecreditOurfirstdecision:Werefusefurthersalestodeadbeats.Wefaceamorecertaincreditdecisionwithourpayingcustomers:Informationisrevealedattheendofthefirstperiod:FutureSalesandtheCreditDe29.3OptimalCreditPolicyCarryingCostsTotalcostsC*CostsindollarsLevelofcreditextended

Attheoptimalamountofcredit,theincrementalcashflowsfromincreasedsalesareexactlyequaltothecarryingcostsfromtheincreaseinaccountsreceivable.Opportunitycosts29.3OptimalCreditPolicyCarr29.3OptimalCreditPolicyTradeCreditismorelikelytobegrantedif:Thesellingfirmhasacostadvantageoverotherlenders.Thesellingfirmcanengageinpricediscrimination.Thesellingfirmcanobtainfavorabletaxtreatment.Thesellingfirmhasnoestablishedreputationforqualityproductsorservices.Thesellingfirmperceivesalong-termstrategicrelationship.Theoptimalcreditpolicydependsonthecharacteristicsofparticularfirms.29.3OptimalCreditPolicyTrad29.4CreditAnalysisCreditInformationFinancialStatementsCreditReportsonCustomer’sPaymentHistorywithOtherFirmsBanksCustomer’sPaymentHistorywiththeFirmCreditScoring:Thetraditional5C’sofcreditCharacterCapacityCapitalCollateralConditionsSomefirmsemploysophisticatedstatisticalmodels29.4CreditAnalysisCreditInf29.5CollectionPolicyCollectionreferstoobtainingpaymentonpast-dueaccounts.CollectionPolicyiscomposedofThefirm’swillingnesstoextendcreditasreflectedinthefirm’sinvestmentinreceivables.CollectionEffort29.5CollectionPolicyCollectiAverageCollectionPeriodMeasurestheaverageamountoftimerequiredtocollectanaccountreceivable.Forexample,afirmwithaveragedailysalesof$20,000andaninvestmentinaccountsreceivableof$150,000hasanaveragecollectionperiodofAverageCollectionPeriodMeasuAccountsReceivableAgingScheduleShowsreceivablesbyageofaccount.Thelongeranaccounthasbeenunpaid,thelesslikelyitistobepaid.AccountsReceivableAgingScheCollectionEffortMostfirmsfollowaprotocolforcustomersthatarepastdue:Sendadelinquencyletter.Makeatelephonecalltothecustomer.Employacollectionagency.Takelegalactionagainstthecustomer.Thereisapotentialforaconflictofinterestbetweenthecollectionsdepartmentandthesalesdepartment.Youneedtostrikeabalancebetweenantagonizingacustomerandbeingtakenadvantageofbyadeadbeat.CollectionEffortMostfirmsfoFactoringThesaleofafirm’saccountsreceivabletoafinancialinstitution(knownasafactor).Thefirmandthefactoragreeonthebasiccredittermsforeachcustomer.FirmFactorCustomerCustomerssendpaymenttothefactorThefactorpaysanagreed-uponpercentageoftheaccountsreceivabletothefirm.ThefactorbearstheriskofnonpayingcustomersGoodsFactoringThesaleofafirm’s29.6HowtoFinanceTradeCreditTherearethreegeneralwaysoffinancingaccountingreceivables:SecuredDebtReferredtoasasset-basedreceivablesfinancing.Thepredominantformofreceivablesfinancing.CaptiveFinanceCompanyLargecompanieswithgoodcreditratingsoftenformafinancecompanyasasubsidiaryofthefirm.SecuritizationOccurswhenthesellingfirmsellsitsaccountsreceivabletoafinancialinstitution,whichthenpoolsthereceivablesandsellssecuritiesbackedbytheseassets.29.6HowtoFinanceTradeCred29.7Summary&ConclusionsThecomponentsofafirm’screditpolicyarethetermsofsale,thecreditanalysis,andthecollectionpolicy.ThedecisiontograntcreditisastraightforwardNPVproblem.Additionalinformationabouttheprobabilityofcustomerdefaulthasvalue,butmustbeweighedagainstthecostoftheinformation.Theoptimalamountofcreditisafunctionoftheconditionsinwhichafirmfindsitself.Thecollectionpolicyisthefirm’smethodfordealingwithpast-dueaccounts—itisanintegralpartofthedecisiontoextendcredit.29.7Summary&ConclusionsTheChapterOutline29.1TermsoftheSale29.2TheDecisiontoGrantCredit:RiskandInformation29.3OptimalCreditPolicy29.4CreditAnalysis29.5CollectionPolicy29.6HowtoFinanceTradeCredit29.7Summary&ConclusionsChapterOutline29.1TermsoftIntroductionAfirm’screditpolicyiscomposedof:TermsofthesaleCreditanalysisCollectionpolicyThischapterdiscusseseachofthecomponentsofcreditpolicythatmakesupthedecisiontograntcredit.IntroductionAfirm’screditpoTheCashFlowsofGrantingCreditCreditsaleismadeCustomermailscheckFirmdepositscheckBankcreditsfirm’saccountAccountsreceivableCashcollectionTimeTheCashFlowsofGrantingCre29.1TermsoftheSaleThetermsofsaleofcomposedofCreditPeriodCashDiscountsCreditInstruments29.1TermsoftheSaleThetermCreditPeriodCreditperiodsvaryacrossindustries.Generallyafirmmustconsiderthreefactorsinsettingacreditperiod:Theprobabilitythatthecustomerwillnotpay.Thesizeoftheaccount.Theextenttowhichgoodsareperishable.LengtheningthecreditperiodgenerallyincreasessalesCreditPeriodCreditperiodsvaCashDiscountsOftenpartofthetermsofsale.Tradeoffbetweenthesizeofthediscountandtheincreasedspeedandrateofcollectionofreceivables.Anexamplewouldbe“3/10net30”Thecustomercantakea3%discountifhepayswithin10days.Inanyevent,hemustpaywithin30days.CashDiscountsOftenpartofthTheInterestRateImplicitin3/10net30Afirmofferingcredittermsof3/10net30isessentiallyofferingtheircustomersa20-dayloan.Toseethis,considerafirmthatmakesa$1,000saleonday0Somecustomerswillpayonday10andtakethediscount.Othercustomerswillpayonday30andforgothediscount.01030$97001030$1,000TheInterestRateImplicitin01030+$970-$1,000Acustomerthatforgoesthe3%discounttopayonday30isborrowing$970for20daysandpaying$30interest:TheInterestRateImplicitin3/10net3001030+$970-$1,000AcustomerthCreditInstrumentsMostcreditisofferedonopenaccount—theinvoiceistheonlycreditinstrument.PromissorynotesareIOUsthataresignedafterthedeliveryofgoodsCommercialdraftscallforacustomertopayaspecificamountbyaspecificdate.Thedraftissenttothecustomer’sbank,whenthecustomersignsthedraft,thegoodsaresent.Banker’sacceptancesallowabanktosubstituteitscreditworthinessforthecustomer,forafee.Conditionalsalescontractsletthesellerretainlegalownershipofthegoodsuntilthecustomerhascompletedpayment.CreditInstrumentsMostcredit29.2TheDecisiontoGrantCredit:RiskandInformationConsiderafirmthatischoosingbetweentwoalternativecreditpolicies:“InGodwetrust—everybodyelsepayscash.”O(jiān)fferingtheircustomerscredit.

Theonlycashflowofthefirststrategyis

Theexpectedcashflowsofthecreditstrategyare:01Weincurcostsupfront……andgetpaidin1periodbyh%ofourcustomers.29.2TheDecisiontoGrantCre29.2TheDecisiontoGrantCredit:RiskandInformationTheNPVofthecashonlystrategyisTheNPVofthecreditstrategyisThedecisiontograntcreditdependsonfourfactors:Thedelayedrevenuesfromgrantingcredit,Theimmediatecostsofgrantingcredit,Theprobabilityofrepayment,hThediscountrate,rB29.2TheDecisiontoGrantCreExampleoftheDecisiontoGrantCreditAfirmcurrentlysells1,000itemspermonthonacashbasisfor$500each.Iftheyofferedtermsnet30,themarketingdepartmentbelievesthattheycouldsell1,300itemspermonth.Thecollectionsdepartmentestimatesthat5%ofcreditcustomerswilldefault.Thecostofcapitalis10%perannum.ExampleoftheDecisiontoGraExampleoftheDecisiontoGrantCreditTheNPVofcashonly:TheNPVofNet30:ExampleoftheDecisiontoGraExampleoftheDecisiontoGrantCreditHowhighmustthecreditpricebetomakeitworthwhileforthefirmtoextendcredit?TheNPVofNet30mustbeatleastasbigastheNPVofcashonly:ExampleoftheDecisiontoGraTheValueofNewInformationaboutCreditRiskThemostthatweshouldbewillingtopayfornewinformationaboutcreditriskisthepresentvalueoftheexpectedcostofdefaults:Inourearlierexample,withacreditpriceof$500,wewouldbewillingtopay$26,000foraperfectcreditscreen.TheValueofNewInformationaFutureSalesandtheCreditDecisionDonotgivecreditGivecreditCustomerpaysh=100%Customerpays(Probability=h)Customerdefaults(Probability=1–h)GivecreditDonotgivecreditOurfirstdecision:Werefusefurthersalestodeadbeats.Wefaceamorecertaincreditdecisionwithourpayingcustomers:Informationisrevealedattheendofthefirstperiod:FutureSalesandtheCreditDe29.3OptimalCreditPolicyCarryingCostsTotalcostsC*CostsindollarsLevelofcreditextended

Attheoptimalamountofcredit,theincrementalcashflowsfromincreasedsalesareexactlyequaltothecarryingcostsfromtheincreaseinaccountsreceivable.Opportunitycosts29.3OptimalCreditPolicyCarr29.3OptimalCreditPolicyTradeCreditismorelikelytobegrantedif:Thesellingfirmhasacostadvantageoverotherlenders.Thesellingfirmcanengageinpricediscrimination.Thesellingfirmcanobtainfavorabletaxtreatment.Thesellingfirmhasnoestablishedreputationforqualityproductsorservices.Thesellingfirmperceivesalong-termstrategicrelationship.Theoptimalcreditpolicydependsonthecharacteristicsofparticularfirms.29.3OptimalCreditPolicyTrad29.4CreditAnalysisCreditInformationFinancialStatementsCreditReportsonCustomer’sPaymentHistorywithOtherFirmsBanksCustomer’sPaymentHistorywiththeFirmCreditScoring:Thetraditional5C’sofcreditCharacterCapacityCapitalCollateralConditionsSomefirmsemploysophisticatedstatisticalmodels29.4CreditAnalysisCreditInf29.5CollectionPolicyCollectionreferstoobtainingpaymentonpast-dueaccounts.CollectionPolicyiscomposedofThefirm’swillingnesstoextendcreditasreflectedinthefirm’sinvestmentinreceivables.CollectionEffort29.5CollectionPolicyCollectiAverageCollectionPeriodMeasurestheaverageamountoftimerequiredtocollectanaccountreceivable.Forexample,afirmwithaveragedailysalesof$20,000andaninvestmentinaccountsreceivableof$150,000hasanaveragecollectionperiodofAverageCollectionPeriodMeasuAccountsReceivableAgingScheduleShowsreceivablesbyageofaccount.Thelongeranaccounthasbeenunpaid,thelesslikelyitistobepaid.AccountsReceivableAgingScheCollectionEffortMostfirmsfollowaprotocolforcustomersthatarepastdue:Sendadelinquencyletter.Makeatelephonecalltothecustomer.Employacollectionagency.Takelegalactionagainstthecustomer.Thereisapotentialfor