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Carleton University
BUSI 2504
Robert Riordan

CHAPTER 20 CREDIT MANAGEMENT Learning Objectives LO1 How firms manage their receivables and the basic components of a firm’s credit policies. LO2 The distinct elements of the terms of sale. LO3 The factors that influence a firm’s decision to grant credit. LO4 How to evaluate credit policy. Answers to Concepts Review and Critical Thinking Questions 2. (LO2) Trade credit is usually granted on an open account. The invoice is the credit instrument. 4. (LO4) 1. Character: determines if a customer is willing to pay his or her debts. 2. Capacity: determines if a customer is able to pay debts out of operating cash flow. 3. Capital: determines the customer’s financial reserves in case problems occur with opera- ting cash flow. 4. Collateral: assets that can be liquidated to pay off the loan in case of default. 5. Conditions: customer’s ability to weather an economic downturn and whether such a down- turn is likely. 6. (LO2) a. B: A is likely to sell for cash only, unless the product really works. If it does, then they might grant longer credit periods to entice buyers. b. A: Landlords have significantly greater collateral, and that collateral is not mobile. c. A: Since A’s customers turn over inventory less frequently, they have a longer inventory period, and thus, will most likely have a longer credit period as well. d. B: Since A’s merchandise is perishable and B’s is not, B will probably have a longer credit period. e. A: Rugs are fairly standardized and they are transportable, while carpets are custom fit and are not particularly transportable. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. (LO2) a. There are 30 days until account is overdue. If you take the full period, you must remit: Remittance = 400($125) Remittance = $50,000 S20-1 b. There is a 1 percent discount offered, with a 10 day discount period. If you take the discount, you will only have to remit: Remittance = (1 – .01)($50,000) Remittance = $49,500 c. The implicit interest is the difference between the two remittance amounts, or: Implicit interest = $50,000 – 49,500 Implicit interest = $500 The number of days’ credit offered is: Days’ credit = 30 – 10 Days’ credit = 20 days 2. (LO1) The receivables turnover is: Receivables turnover = 365/Average collection period Receivables turnover = 365/36 Receivables turnover = 10.139 times And the average receivables are: Average receivables = Sales/Receivables period Average receivables = $47,000,000 / 10.139 Average receivables = $4,635,616 4. (LO1) The daily sales are: Daily sales = $19,400 / 7 Daily sales = $2,771.43 Since the average collection period is 34 days, the average accounts receivable is: Average accounts receivable = $2,771.43(34) Average accounts receivable = $94,228.57 5. (LO2) The interest rate for the term of the discount is: Interest rate = .01/.99 Interest rate = .0101 or 1.01% And the interest is for: 35 – 10 = 25 days So, using the EAR equation, the effective annual interest rate is: EAR = (1 + Periodic rate) – 1 365/25 EAR = (1.0101) – 1 EAR = .1580 or 15.80% a. The periodic interest rate is: Interest rate = .02/.98 S20-2 Interest rate = .0204 or 2.04% And the EAR is: EAR = (1.0204) 365/2– 1 EAR = .3431 or 34.31% b. The EAR is: EAR = (1.0101) 365/5– 1 EAR = .0761 or = 7.61% c. The EAR is: 365/20 EAR = (1.0101) – 1 EAR = .2013 or 20.13% 6. (LO1) The receivables turnover is: Receivables turnover = 365/Average collection period Receivables turnover = 365/39 Receivables turnover = 9.3590 times And the annual credit sales are: Annual credit sales = Receivables turnover × Average daily receivables Annual credit sales = 9.3590($47,500) Annual credit sales = $444,551.28 8. (LO1) The average collection period is the net credit terms plus the days overdue, so: Average collection period = 30 + 8 Average collection period = 38 days The receivables turnover is 365 divided by the average collection period, so: Receivables turnover = 365/38 Receivables turnover = 9.6053 times And the average receivables are the credit sales divided by the receivables turnover so: Average receivables = $8,400,000 / 9.6053 Average receivables = $874,520.55 9. (LO4) a. The cash outlay for the credit decision is the variable cost of the engine. If this is a one-time order, the cash inflow is the present value of the sales price of the engine times one minus the default probability. So, the NPV per unit is: NPV = –$1,600,000 + (1 – .005)($1,870,000)/1.029 NPV = $208,211.86 per unit The company should fill the order. b. To find the breakeven probability of default, π, we simply use the NPV equation from part a, set it equal to zero, and solve for π. Doing so, we get: S20-3 NPV = 0 = –$1,600,000 + (1 – π)($1,870,000)/1.029 π = .1196 or 11.96% We would not accept the order if the default probability
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