Changing the Credit Period

Transient Ltd is currently operating at the 65% capacity utilization level with its sales pegged at Rs 950
lakhs. As per its current credit policy the firm is offering a credit period of 20 days. The average
collection period for Transient Ltd is 30 days. In view of increased competition that has of late started
to erode its bottom-line the firm's management has been contemplating relaxing its credit terms. As per
management's projections such a liberalization of firm's credit policy is likely to boost its sales by
30%.However, since the proposed change is likely to increase the average credit period for the firm by
30 days, one section of company management is opposed to such a change proposed in the credit policy
and is advocating a status quo. The variable costs for the firm are 75% of the sales. Are you in favour
of such a change proposed in the firm's credit policy? Assume the opportunity cost of capital for
Transient Ltd is 12%.

Solution

Current Sales (Rs in lakhs) 950

Sales under proposed credit policy (Rs in lakhs) 1,235
Incremental sales under proposed credit policy (Rs in lakhs) 285
Variable cost (as % of sales) 75%
,Contribution (as % of sales) 25%
Profits on incremental sales (Rs In lakhs) 71.25
Current average collection period (in days) 30
Average collection period under proposed policy (in days) 60
Receivables turnover ratio (Present policy) 12
Receivables turnover ratio (Proposed policy) 6
Opportunity cost of capital for the firm 12%

Comparison of present and proposed credit policy

Present Proposed
(Rs In lakhs)
Average daily sales (Sales/360) 2.64 3.43
Receivables (Sales/ Receivables turnover) 79.20 205.83
Cost of receivables at 12% 9.50 24.70
Incremental cost of receivables - 15.20
Incremental profit (net of cost) 56.05

Since the change in credit policy is expected to create value of Rs 56.05 lakhs the proposed
lengthening of credit period is recommended for Transient Ltd.

Choosing Credit Policies

Networking Ltd, the leader in networking business in the country has been enjoying its status of market
leader, and in a virtual monopolistic situation, has been selling on 100% cash basis. The emerging
competition in the sector from new players has forced the firm to revisit its terms of sales and company
is evaluating two alternate credit policy options. The two options are:

Credit Policy A Credit Policy B

Collection period (in months) 1.0 2.5
Increase in Sales (in %) 15.0 17.0
Bad debts losses (in %) 1.5 3.0
The current sales of the firm are Rs 400 lakhs and the total costs are Rs 312 lakhs. Which of the two
policies should be chosen by Networking Ltd in case they want to maintain their current level of
profitability? Assume that the firm's required return on investment in its receivables is 14%.

Solution:
Present sales (Rs in lakhs) 400
Total cost (Rs In lakhs) 312
Present profits (Rs In lakhs) 88
Present profitability (in %) 0.22 or 22%
Required rate of return in receivables 0.14 or 14%

Comparison of two policies

(Rs In lakhs) Credit Policy A Credit Policy B

A. BENEFITS
Additional Sales 60 68
Profitability on additional sales @ 22% 13.20 14.96
B. COSTS
Additional bad debts losses 1.50% 0.90 3.00% 2.04
Additional receivables 5.00 14.17
Investment in additional receivables @ 78% 3.90 11.05
Cost of additional investments @ 14% 0.55 1.55
B Additional cost 1.45 3.59
Incremental profitability (A – B) 11.75 11.37

Since Policy A is likely to yield more profits than Policy B, Policy A should be chosen by Networking
Ltd.

Evaluating Discount in Credit Policy

Green & Clean has been performing well on the profitability front with its sales growing at average 15-
20% in the past four years. However the firm has been facing liquidity problems in the recent past. In
order to improve its liquidity position the company management is considering liberalizing its credit
terms by introducing a cash discount. Such a measure is expected to induce the debtors to pay their
dues before the current maturity period of 30 days and therefore, is likely to bring down its average
collection period by 15 days. In net terms, the funds tied up in receivables are likely to come down due
to the introduction of cash discount. Should Green and Clean introduce cash discount?
The current sales of the firm are Rs 655 lakhs. The company is planning a cash discount policy of 3/10
net 30. Based on the market research done by company it is expected that 80% of the accounts are
likely to avail the cash discount facility. The company's required rate of return on its receivables is
18%.

Solution:

Facts of the problem:

Present Sales (Rs In lakhs) 655
Collection period without cash discount (in days) 30
Collection period with cash discount (in days) 15
Firm’s Required rate of return 18%
Percentage of accounts availing cash discount 80%
Cash discount 3%
 Cost-benefit analysis of introduction of cash discount

Rs lakhs
Accounts Receivables without cash discount
Collection Period (without cash discount)
Sales  360 54.58
Accounts Receivables with cash discount
Collection Period (with cash discount)
Sales  360 27.29
Reduction in accounts receivables on account of cash discount (54.58 lakhs –
27.29 lakhs) 27.29
Savings due to reduced blockage of funds in accounts receivables (Rs in
lakhs) = (27.29 x 18%) 4.91
Loss on account of cash discount = (Present Sales x 80% x 3%) 15.72
Net gain on account of proposed cash discount -10.81

Since the cost of cash discount outweighs their savings the introduction of cash discount is not
advisable.

Multi period Analysis of Changing the Credit Policy

The current sales of ABC Ltd (in lakhs) 285.46

Expected Sales (in lakhs) 310.00

Sales are expected to grow at 7.5% p.a. The company is considering its terms of sale. The change in the
credit policy is likely to increase the accounts receivables turnover period from 45 days to 60 days.
Under the proposed terms, the next year's sales are expected to increase to a level of Rs 342 lakh,
although the growth in sales is likely to remain same as under the present policy. Variable costs of
production are 70% of the gross sales and the appropriate risk adjusted discount rate for the cash flows
is 13.5%. Expected life of the product being sold by the company is 5 years. The production equipment
currently in place has a maximum capacity to produce enough of output for a maximum of Rs 360 lakh
in sales.
Under the present policy, the firm will have to purchase additional production capacity at the end of the
fourth year at a cost of Rs 150 lakh. This capacity will be scrapped at the end of the life of the product
at the salvage value of Rs 79 lakh. If the firm implements the proposed policy, the capital expenditure
for the additional capacity will be made at the end of the second year for Rs 188 lakh and will have a
salvage value of Rs 84 lakh at the end of the product's life. The firm's policies are such that the
inventory turnover is 20 times a year with this ratio, based on gross sales. Under the present policy bad
debts total 2 % of sales; under the proposed policy this is likely to increase to a level of 2.5 % of the
sales. Collection costs for the firm is not likely to change if the new policy is adopted. The firm does
not offer a cash discount.
The firm is in the 38.5% tax brackets and depreciates its assets from their initial value to their expected
salvage value by the straight line method. It is anticipated that the inventory and the receivables shall
fetch their book value.

Should the firm make proposed changes in its terms of sales?

 Solution:

Present Policy:
Facts of the problem
Last year's gross sales 285.46
First year's gross sales 310.00
Growth rate 7.50%
Receivables turnover (in days) 45.00
Bad debts expenses (as a % of sales) 2.00%
Discount rate 13.50%
Inventory turnover (times) 25.00
Variable cost ratio 70.00%
Tax rate 38.50%

Year
0 1 2 3 4 5
Gross Sales 285.46 310.00 333.25 358.24 385.11 414.00
Sales net of bad debts 279.75 303.80 326.59 351.08 377.41 405.72
Receipts
Accounts receivables balance 34.97 37.98 40.82 43.88 47.18 50.71
Cash Receipt from sales 244.78 300.79 323.74 348.02 374.12 402.18
Payments
Inventory balance 11.42 12.40 13.33 14.33 15.40 16.56
Increase in the inventory 0.98 0.93 1.00 1.07 1.16
Cost of goods produced for sale 217.00 233.28 250.77 269.58 289.80
Total cost of goods produced for sale
217.98 234.21 251.77 270.65 290.95
Capital Expenditure 150.00
Salvage value of new equipment 79.00

Income Tax Calculations

Sales net of bad debts 303.80 326.59 351.08 377.41 405.72

Cost of goods produced for sale 217.00 233.28 250.77 269.58 289.80
Depreciation 71.00

Earnings Before Tax 86.80 93.31 100.31 107.83 44.92

Taxes (@38.5%) 33.42 35.92 38.62 41.52 17.29
Earnings After Tax 53.38 57.39 61.69 66.32 27.63

Computation of NPV

Cash Receipt from Sales - 300.79 323.74 348.02 374.12 402.18

Total cost of goods produced for sale
- 217.98 234.21 251.77 270.65 290.95
Capital Expenditure - 150.00
Salvage value of new equipment - 79.00
Recovery of receivables - 50.71
Recovery on inventory - 16.56
Taxes Paid - 33.42 35.92 38.62 41.52 17.29
Net Cash Flow - 49.394 53.608 57.628 -88.050 240.206
Total NPV 199.02
 Proposed Policy Facts of the problem

Last year's gross sales (Rs in lakhs) 285.46

First year's gross sales (Rs In lakhs) 342.00
Growth rate (in %) 7.50
Receivables turnover (in days) 60
Bad debts expenses 2.5%
Discount rate 13.5%
Inventory turnover (times) 20
Variable cost ratio 70%
Tax rate 38.50%

Year
0 1 2 3 4 5
Gross Sales 285.46 310.00 333.25 358.24 385.11 414.00
Sales net of bad debts 279.75 303.80 326.59 351.08 377.41 405.72
Receipts
Accounts receivables balance 34.97 37.98 40.82 43.88 47.18 50.71
Cash Receipt from sales 244.78 300.79 323.74 348.02 374.12 402.18
Payments
Inventory balance 11.42 12.40 13.33 14.33 15.40 16.56
Increase in the inventory 0.98 0.93 1.00 1.07 1.16

Cost of goods produced for sale 217.00 233.28 250.77 269.58 289.80
Total cost of goods produced for sale 217.98 234.21 251.77 270.65 290.95
Capital Expenditure 150.00
Salvage value of new equipment 79.00

Income Tax Calculations

Sales net of bad debts 303.80 326.59 351.08 377.41 405.72
Cost of goods produced for sale 217.00 233.28 250.77 269.58 289.80
Depreciation 71.00
Earnings Before Tax 86.80 93.31 100.31 107.83 44.92
Taxes (@38.5%) 33.42 35.92 38.62 41.52 17.29
Earnings After Tax 53.38 57.39 61.69 66.32 27.63

Computation of NPV

Cash Receipt from Sales 324.26 354.29 380.86 409.43 440.13

Total cost of goods produced for sale 242.23 258.64 278.04 298.89 321.30
Capital Expenditure 188.00
Salvage value of new equipment 84.00
Recovery of receivables 74.22
Recovery on inventory 22.84
Taxes Paid 36.21 38.92 55.19 58.33 61.70
Net Cash Flow 45.83 -131.27 47.64 52.21 238.18
Total NPV 128.97

Since the NPV from present credit policy (Rs 199.02 lakh) is higher than the NPV from the proposed
credit policy (128.97 lakh) the change in credit policy is likely to erode value. Hence it is suggested
that the firm retains its present credit policy.