Problem I - Working Capital Policy and Financing

1. The four variables that make up the credit policy of a firm consist of the credit standards, credit period,
cash discount and collection policy. The credit standards provide regulations and limits when it comes
to extending credit to customers, while the credit period is the length of time allocated to the
customers to pay for their purchases. Cash discounts are allowed to customers when they pay for
their purchases with an indicated discount period. Lastly, the collection policy refers to the firm’s
method when it comes to the collection and monitoring of its receivables.
If the credit policy would be tightened it may alter its credit standards to be tight, credit period to be
lower, decrease the discount period while maintaining the percent of cash discount, and applying
greater efforts in collecting its receivable. A tight credit policy can possible decrease the sales, the
level of receivables held and the amount of bad debt expense.
2. The five C’s of credit includes the character, capital, conditions, capacity and collateral. Character
refers to the credit history and reputation of the debtor and this may be a factor in the credit standard
of the firm. A high credit rating of the debtor can ease the strictness of the credit policy. On the other
hand, capital refers to the amount of money contributed by the borrower to an investment and this
may affect the level of credit standard and collection policy of the lender. Accordingly, lenders are
more willing to extend credit for borrowers with great seriousness when it comes to handling money.
Capacity obviously refers to the capability of the borrower to repay his/her debt and this is a very
significant factor in the credit standard, period and collection policy. Conditions are the agreed
settlement of the debt, which can be in the form of interest. This may affect the collection policy,
credit period, cash discounts and credit standards of the credit policy. Finally, collateral can ease the
credit standard of the credit policy because it can grant security to the lender in case the borrower
defaults on the debt.
3. The average collection period is a measure of average length of time of customers to pay off their
credit purchases while the daily sales outstanding is often compared with an industry average.

 Current DSO
.63(10 days) + .34(30 days) +.03(60 days) = 18.3 days
 Proposed DSO
.70(20 days) +.11(45 days) + .19(90 days) = 36.05 days
4. Bad debt losses
 Current: 18M x .02 = 360,000
 Proposed: 22M x .04 = 880,000
5. Discounts
 Current: 18M x .63 x .02 = 226,800
 Proposed: 22M x .70 x .03 = 462,000
6. Cost of Carrying Receivables

 Current: = 18M x 18.3/360 = 915,000

 Proposed: = 22M x 36.05/360 = 2,203,056
 Cost of carrying receivables:
 Current: 915,000 x .75 x .10 = 68,625
 Proposed 2,203,056 x .75 x .10 = 165,229.20
7. Expected Incremental Profit
Incremental Profit 1,000,000 [(22,000,000 - 18,000,000) x .25]
Incremental Bad debt 520,000 (880,000 - 360,000)
Incremental Discount 235,200
Incremental Cost of AR 96,604.20
EBIT 148,195.80
Less: 40% taxes 59,278.32
Incremental Profit after Tax 88,917.48

The change in credit policy should be made because the incremental profit exceeds incremental cost.
8.
9.
Sales 18,000,000
Less: Discount 378,000 (18M x .70 x .03)
Net Sales 17,622,000
Variable Cost 13,500,000
Gross Profit 4,122,000
Bad Debt Losses 720,000
Cost of Carrying Accounts Receivable 135,187.50 [(18M x 36.05/360) x .75 x .10]
Profit Before taxes 3,266,812.50
Less: Taxes (40%) 1,306,725
Profit After Taxes 1,960,087.50