The document analyzes the factors to consider when evaluating a credit policy, using the example of Locust Software. It examines: [1] The potential revenue and cost effects of granting credit; [2] How to calculate the net present value (NPV) of switching to a net 30 day credit policy; [3] That for Locust Software, the NPV is positive $9,400, so the switch is profitable; [4] The break-even point is an increase of 3.43 units per month.
The document analyzes the factors to consider when evaluating a credit policy, using the example of Locust Software. It examines: [1] The potential revenue and cost effects of granting credit; [2] How to calculate the net present value (NPV) of switching to a net 30 day credit policy; [3] That for Locust Software, the NPV is positive $9,400, so the switch is profitable; [4] The break-even point is an increase of 3.43 units per month.
The document analyzes the factors to consider when evaluating a credit policy, using the example of Locust Software. It examines: [1] The potential revenue and cost effects of granting credit; [2] How to calculate the net present value (NPV) of switching to a net 30 day credit policy; [3] That for Locust Software, the NPV is positive $9,400, so the switch is profitable; [4] The break-even point is an increase of 3.43 units per month.
The document analyzes the factors to consider when evaluating a credit policy, using the example of Locust Software. It examines: [1] The potential revenue and cost effects of granting credit; [2] How to calculate the net present value (NPV) of switching to a net 30 day credit policy; [3] That for Locust Software, the NPV is positive $9,400, so the switch is profitable; [4] The break-even point is an increase of 3.43 units per month.
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Notes in Fin
T 2.1 Analyzing Credit Policy
Analyzing Credit Policy There are factors that influence the decision to grant credit. Granting credit makes sense only if the NPV from doing so is positive. We thus need to look at the NPV of the decision to grant credit. The five basic factors to consider when evaluating credit policy: 1. Revenue effects: If the firm grants credit, then there will be a delay in revenue collections as some customers take advantage of the credit offered and pay later. However, the firm may be able to charge a higher price if it grants credit and it may be able to increase the quantity sold. Total revenues may thus increase. 2. Cost Effects: Although the firm may experience delayed revenues if it grants credit, it will still incur the costs of sales immediately. Whether the firm sells for cash or credit, it will still have to acquire or produce the merchandise (and pay for it). 3. Cost of debt: When the firm grants credit, it must arrange to finance the resulting receivables. As a result, the fi rm’s cost of short-term borrowing is a factor in the decision to grant credit. 4. Probability of nonpayment: If the firm grants credit, some percentage of the credit buyers will not pay. This cannot happen, of course, if the firm sells for cash. 5. Cash discount: When the firm offers a cash discount as part of its credit terms, some customers will choose to pay early to take advantage of the discount. Evaluating a Proposed Credit Policy To illustrate how credit policy can be analyzed, we will start with a relatively simple case. Locust Software has been in existence for two years, and it is one of several successful firms that develop computer programs. Currently, Locust sells for cash only. Locust is evaluating a request from some major customers to change its current policy to net one month (30 days). To analyze this proposal, we define the following: P = Price per unit V = Variable cost per unit Q = Current quantity sold per month Q1 = Quantity sold under new policy R = Monthly required return For now, we ignore discounts and the possibility of default. Also, we ignore taxes because they do not affect our conclusions. To illustrate the NPV of switching credit policies, suppose we have the following for Locust: P = $49 v = $20 Q = 100 Q1= 110 If the required return, R, is 2 percent per month, should Locust make the switch? Currently, Locust has monthly sales of P x Q = $4,900. Variable costs each month are v x Q = $2,000, so the monthly cash flow from this activity is: Cash flow with old policy = (P – v) Q = ($49 – 20) x 100 = $2,900 Note: This is not the total cash flow for Locust, of course, but it is all that we need to look at because fixed costs and other components of cash flow are the same whether or not the switch is made. If Locust does switch to net 30 days on sales, then the quantity sold will rise to Q 1 = 110. Monthly revenues will increase to P x Q1 and costs will be v x Q 1. The monthly cash flow under the new policy will thus be: Cash flow with new policy = (P – v) Q1 = ($49 – 20) x 110 = $3,190 The relevant incremental cash flow is the difference between the new and old cash flows: Incremental cash flow = (P – v) (Q1 – Q) = ($49 – 20) x (110 – 100) = $290 This says that the benefit each month of changing policies is equal to the gross profit per unit sold, P – v = $29, multiplied by the increase in sales, Q 1 – Q = 10. The present value of the future incremental cash flows is thus: PV = [(P – v) (Q1 – Q)] / R PV = ($29 x 10) /.02 = $14,500 Now that we know the benefit of switching, what is the cost? There are two components to consider. First, because the quantity sold will rise from Q to Q 1, Locust will have to produce Q1 – Q more units at a cost of v (Q1 – Q) = $20 = (110 – 100) = $200. Second, the sales that would have been collected this month under the current policy (P x Q = $4,900) will not be collected. Under the new policy, the sales made this month will not be collected until 30 days later. The cost of the switch is the sum of these two components: Cost of switching = PQ + v (Q1 – Q) = $4,900 + 200 = $5,100 NPV of switching = - [PQ + v (Q1 – Q)] + [(P – v) (Q1 – Q)] / R For Locust, the cost of switching is $5,100. As we saw earlier, the benefit is $290 per month, forever. At 2 percent per month, the NPV is: NPV of switching = - [PQ + v (Q1 – Q)] + [(P – v) (Q1 – Q)] / R = - $5,100 + (290/.02) = - $5,100 + 14,500 = $9,400 Therefore, the switch is very profitable. Break-Even Application Based on our discussion thus far, the key variable for Locust is Q 1 – Q, the increase in unit sales. The projected increase of 10 units is only an estimate, so there is some forecasting risk. Under the circumstances, it is natural to wonder what increase in unit sales is necessary to break even. Earlier, the NPV of the switch was defined as: NPV = -[PQ + v (Q1 – Q)] + [(P – v) (Q1 – Q)] / R We can calculate the break-even point explicitly by setting the NPV equal to zero and solving for (Q1 –Q): NPV = 0 = - [PQ + v (Q1 – Q)] + [(P – v) (Q1 – Q)] / R Q1 – Q = PQ / [(P – v) / R – v] Q1 – Q = $4,900 / (29/.02 – 20) = 3.43 units This tells us that the switch is a good idea for as long as Locust is confident that it can sell at least 3.43 more units per month. References: Lasher (2014). Practical Financial Management, (7th Edition). Philippines: Cengage Learning Philippine Edition Ross, et al. (2010). Fundamentals of Corporate Finance. (9th Edition). New York, NY: McGraw-Hill Irwin
