Terms of Sale Decision Chapter 5 Modern Working Capital Management Text and CasesFrederick C. Scherr

1. August 14, 2015
1
Fatima;
Terms of Sale Decisions
Working Capital Management
FIN 6407
Terms of Sale Decision
Chapter 5
Text: Modern Working Capital Management
Text and Cases
Frederick C. Scherr

2. August 14, 2015 2Fatima;
Terms of Sale Decisions
Main Focus:
Provides an introduction to the
management of accounts receivable
Discusses decision methodologies with
respect to the what terms of sale should
the firm use

3. August 14, 2015 3Fatima;
Terms of Sale Decisions
Creation of Accounts Receivable-Two Ways
a. Making advance payments to suppliers of
inventories to ensure timely supply
b. Selling a firm’s outputs on credit to the
“sundry debtors”
In an average, it constitutes 20%-30% of the
total assets of the manufacturing firms

4. August 14, 2015 4Fatima;
Terms of Sale Decisions
Why we grant credit?
The granting of credit from one business
to another for the purchase of goods or
services –trade credit
 Trade credit is a major means of
obtaining debt financing by businesses,
more than commercial borrowings
 Accounts receivable-arises from granting
trade credit-conceived one-fourth of total
assets

5. August 14, 2015 5Fatima;
Terms of Sale Decisions
Why we grant credit?
 Apart from the basic attributes of the
products, trade-credit itself influences the
distributor’s preferences to push the products
of a particular manufacturer
For customers, trade-credit effectively reduces
the price of the product because of time value
of money
 For the manufacturer, motives for extending
trade credit are operating, marketing and
financial

6. August 14, 2015 6Fatima;
Terms of Sale Decisions
Trade credit performs useful economic
functions, like-
 Can provide the opportunity for financial
arbitrage
 Help to overcome an information problem
in the sale of goods
 May make the payment for goods less
difficult
 Trade-off between marketing and finance
strategies

7. • A company having investments in
manufacturing assets of Rs. 20,000
produces 360 units a year at a cost of
Rs. 100 per unit. Market price of the
product is Rs. 150 per unit. The
company can sell its entire output to
distributors at a 10 percent trade
discount on the listed price with a credit
period of two-months.
Terms of Sale Decisions

8. a. Should the company go for direct
marketing with a capital investment of
Rs.4000 in marketing assets? In
addition to that marketing department’s
overheads will claim Rs.3000 per year.
But holding of receivables will come
down to one month.
Terms of Sale Decisions

9. b. If working with external distribution
channel, the company is currently
expending an amount of Rs.1800 per
annum for continuous market research
and credit information through external
agencies which will be reduced to Rs.
300 per annum under Option II, then
what will be the new decision?
Terms of Sale Decisions

10. Maximum length of trade credit
Example: Basic price of the product is
$10,000; cost of capital is 24% per
annum, cost of sales is $8000,
determine the maximum trade credit
period ranging from 3 months to 12
months.
Terms of Sale Decisions
Limit the maximum length of credit
period that a firm can allow on its
receivables

11. Determination of maximum rate of
cash discount
• Trade-off between the cost of giving up
some part of invoice price and the benefits
of quickening of cash inflows, increase in
sales, reduction in outstanding receivables
and a possible bad-debt losses

12. • Example: Present annual sales of a firm is
Rs.1000 crore. Sales made on credit net 60
days, 50 percent of the receivables pay
within 60 days, and the rest pay on 120
days. It is currently considering offering a
cash discount of 2 percent (2/10, net 60). It
is expected that who are paying within 60
days they would pay on their previous
pattern. Cost of capital is 20 percent.
Determine if to alter the cash discount policy
or not?
Terms of Sale Decisions

13. August 14, 2015
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Fatima;
Terms of Sale Decisions
Possibility of Financial Arbitrage
 Granting credit is equivalent to granting a
loan from the seller to the buyer
 The seller bears the cost of this
loan….how? Cost of trade credit is same as
selling at a discount.
 Buyer may not be able to borrow at
economical rate, sellers can borrow from
the capital market and lend it to the buyer
through trade credit

14. August 14, 2015 14Fatima;
Terms of Sale Decisions
Buyer’s Imperfect Knowledge Regarding the
Quality of the Products Purchased
If payment for purchases is not made
instantly, the buyer has the option to reduce
the price and return products for defective
qualities
 A large number of staffs are engaged in the
transaction process, there is chance of theft
and fraud in cash sales

15. August 14, 2015 15Fatima;
Terms of Sale Decisions
Costs, Revenues and Credit Decisions
 Firm’s terms of sales and credit-granting
decisions affect it’s sales volume
Also affects the level and timing of certain
costs
Policy evaluation procedures have to
compare these sales and costs effect

16. August 14, 2015 16Fatima;
Terms of Sale Decisions
It is expected to influence:
 Collections on Sales would increase
 Investment in Inventory due to increase or
decrease in inventory
 Cost of Sales would be influenced as
several types of costs like direct labor, direct
material, etc.
 Discounts and Bad Debt Expenses are the
deductions from the expected level of cash
inflows

17. August 14, 2015
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Fatima;
Terms of Sale Decisions
It is expected to influence:
 Collection costs of accounts receivable
are costly
 Credit policies can influence timing and
amount of future capital expenditures
 Changes in credit policy may also affect
the firm’s tax payments
 Salvage and Recovery Values of
accounts receivable, inventory and capital
assets

18. August 14, 2015
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Fatima;
Terms of Sale Decisions
Terms of Sale Decisions: Standard Approach
Terms of sale must in almost all cases, be
same for all the firm’s customers, although
the selling firm may require some specific
buyers to pay cash because of the high
costs of granting credit to them

19. August 14, 2015
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Fatima;
Terms of Sale Decisions
Terms of Sale involves three
parameters
The cash discount
The cash discount period
Optimum terms of sales that ensures
highest possible Net Present Values
Analyze the effects of changes of terms, the positive
changes will make move toward the optimum terms
of sale

20. 20
Terms of Sale Decisions
A firm is changing it’s terms of sales from net
30 days to net 60 days (it does not offer a
cash discount ), the change in terms will not
affect the collection expenses or bad debt
expenses. The firm’s current sales are $ 50
million per year, and it is estimated that the
new policy would increase the sales to $ 53
mil. The out-of-pocket costs of materials are
80 percent of sales and the required rate of
return is 12 percent. Should the firm take the
change?

21. August 14, 2015 21Fatima;
Credit-Granting Decision
Credit-Granting Decision
Management’s decision-making about which
of the selling firm’s credit applicants will be
allowed to purchase goods and services
on credit, and which will be required to pay
cash. Also called as credit standard policy.

22. August 14, 2015 22Fatima;
Credit-Granting Decision
Credit-Granting Decision
A selling-firm can either follow the same rule
for every customer. Again it can analyze
each customer separately to grant credit.
Either a standard set of rules for all
customers
Or customized on the basis of each
customer’s profile

23. 23
Credit-Granting Decision
Terms of Sales Vs. Credit-Granting
Decision
The firm’s terms of sale policy is in
aggregate across customers, the level of
analysis for credit-granting policy can be
at the level of individual customers.
Terms of sale decision are made
infrequently (when required), while credit-
granting decision occurs constantly as
when a new customer comes and old
customers are reviewed.

24. August 14, 2015 24Fatima;
Credit-Granting Decision
Credit-Granting Decision Policy
Questions
 How much information should the firm
collect on each credit applicant?
 What method of analysis should the seller
use to determine which applicants should
be granted credit?

25. August 14, 2015 25Fatima;
Credit-Granting Decision
Credit-Granting Decision Policy
Questions
 How many periods should be considered
in evaluating the expected cash flows from
selling to an applicant?
 How should the credit granting
parameters of credit applicants be
estimated?

26. August 14, 2015 26Fatima;
Credit-Granting Decision
Information Costs and Credit-Granting
Decision
The selling firm evaluates the cash flows
that would result from granting credit to a
credit applicant versus those that would
result if credit were not granted to that
applicant.
 These cash flows result from the cost and
revenue effects of the decision.

27. August 14, 2015
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Fatima;
Credit-Granting Decision
 Changes in sales and collections, cost of
productions, bad debt expenses, etc. that
are related with granting or not granting
credit.
 These sources vary in their costs and
their type of information they provide.
 Several sources of information are:

28. August 14, 2015
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Fatima;
Credit-Granting Decision
 The seller’s prior experience with the
customer
 Credit agency ratings and reports
 Personal contract with applicant’s bank
and other creditors
 Analysis of the applicant’s financial
statements
 Customer visit

29. August 14, 2015
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An applicant has placed an order with the seller
for $75,000 worth of goods and services
which actually costs $60,000 to provide. If the
applicant pays, it is expected that payment
will be received in 60 days. If the applicant
defaults, a 10 percent recovery is expected,
and it is expected that the courts will take two
years to liquidate the firm and disburse the
proceeds. The estimated probability of default
is 25 percent and the required return is 10
percent per year. Should the credit be
granted?

30. • A seller facing a tax-rate of 33 percent has
received an order for $100,000, the cost of
materials for serving this order will be $
85,000; the estimated probability of default
is 10 percent and the estimated recovery
rate is 20 percent. If the applicant does not
default, the payment is expected within 75
days; if the applicant does default, the
disbursement from the court will be received
in three years. The required rate of return is
13 percent per year. What is the expected
net present value of the credit?

31. Thank You