1. Delta Company has current sales of Rs 30 crore. To push up sales, the company is considering a more liberal credit policy. The current average collection period of the company is 25 days. If the collection period is extended, sales increase in the following manner.
Credit Increase in Increase in Sales Policy Collection Period (Rs in lakh)
X 15 days 12
Y 25 days 27
Z 35 days 47
The company is selling its product at Rs 10 each. Average cost per unit at the current level is Rs 8 and variable cost per unit Rs 6. If the company required a return of 12 per cent on its investment, which credit policy is desirable? State your assumptions. (Assume a 360-day year).
2. The credit terms of a firm currently is ―net 30.‖ It is considering changing it to ―net 60.‖ This will have the effect of increasing the firm‘s sales. As the firm will not relax credit standards, the bad-debt losses are expected to remain at the same percentage, i.e., 3 per cent of sales. Incremental production, selling and collection costs are 80 per cent of sales and expected to remain constant over the range of anticipated sales increases. The relevant opportunity cost for receivables is 15 per cent. Current credit sales are Rs 300 crore and current level of receivables is Rs 30 crore. If the credit terms are changed, the current sale is expected to change to Rs 360 crore and the firm‘s receivables level will also
Prepared by A.K.Mohideen, MBA, M.Phil, (Ph.D)
31 increase. The firm‘s financial manager estimates that the new credit terms will cause the firm‘s collection period to increase by 30 days.
(a) Determine the present collection period and the collection period after the proposed change in credit terms.
(b) What level of receivables is implied by the new collection period?
(c) Determine the increased investment in receivables if the new credit terms are adopted. (d) Are the new credit terms desirable?
3. The Syntex Company is planning to relax its credit policy to motivate customers to buy on credit terms of net 30. It is expected that the variable costs will remain 75 per cent of sales. The incremental sales are expected to be on credit basis. For the perceived increase in risk in liberalising the credit terms, the company requires higher required return. If the following is the projected information, which credit policy should the company pursue?
Credit Policy Required Return Collection New Sales Period (Rs)
A 20% 40 600,000
B 25% 45 500,000
C 32% 55 400,000
D 40% 70 300,000
4. X Ltd has current annual sales of Rs 60 crore and an average collection period of 30 days. The company is considering of liberalising its credit policy. If the collection period is extended, sales and bad debt are expected to increase in the following way:
Increase in Increase in
Collection Sales Per cent Bad Credit Policy Period Rs (crore) Debt Losses
I 15 days 4.0 1.5
II 30 days 4.5 1.7
III 45 days 5.3 2.0
IV 60 days 6.5 2.5
The firm sells its product for Rs 10 per unit. Average cost at current level of sales is 90 per cent for sales and variable cost is 80 per cent of sales. If the current bad debt loss is 1.5 per cent of sales and the required return is 18 per cent, which credit policy should be pursued? (Assume a 360-day year). State your assumptions.
5. A company has a 15 per cent required rate of return. It is currently selling on terms of net 10. The credit sales of the company are Rs 120 crore a year. The company‘s collection period currently is 60 days. If company offered terms of 2/10, net 30, 60 per cent of its customers will take the discount and the collection period will be reduced to 40 days. Should the terms be changed?
6. A firm has current sales of Rs 7,200,000. The firm has unutilised capacity; therefore, with a view to boost its sales, it is considering lengthening its credit period from 30 days to 45 days. The average collection period will also increase from 30 to 45 days. Bad-debt losses are estimated to remain constant at 3 per cent of sales. The firm‘s sales are expected to increase by Rs 360,000. The variable production,
administrative and selling costs are 70 per cent of sales. The firm‘s corporate tax rate is 35 per cent, and it requires an after-tax return of 15 per cent on its investment. Should the firm change its credit period?
7. A firm has current sales of Rs 720,000. It is considering offering the credit terms ‗2, 10, net 30‘ instead of ‗net 30.‘ It is expected that sales will increase by Rs 20,000 and the average collection period will reduce from 30 days to 20 days. It is also expected that 50 per cent of the customers will take discounts and pay on 10th day and remaining 50 per cent will pay on 30th day. Bad-debt losses will remain at 2 per cent of sales. The firm‘s variable cost ratio is 70 per cent, corporate tax rate is 50 per cent and opportunity cost of investment in receivables is 10 per cent. Should the company change its credit terms?
8. The Electro Limited is a distributor of electric equipments. Its sales in 2004 amounted to Rs 22 crore and after tax profit Rs 1.10 crore.
The company has been experiencing a declining profit margin for the last three years. It is felt that this is due to the loose credit policy. On investigation, a group of slow paying customers was identified. It
Prepared by A.K.Mohideen, MBA, M.Phil, (Ph.D)
32 is recommended that the credit policy should be tightened to eliminate them. Sales to this group amounted to about 20 per cent of the company‘s total sales.
Table 28.8 gives information about the company‘s cost structure. It is expected that if the slow-paying accounts are eliminated only variable costs would decline. It is also believed that bad-debt and collection expenses are entirely attributable to these accounts. Using this information, you are required to allocate Electro‘s income and expenses between ―slow-paying‖ accounts and ―good‖ accounts.
Table 28.8: The Electro Limited: Fixed and Variable Costs (Per cent of Sales)
Total Fixed Variable
Cost of goods sold 85.0 – 85.0
Selling 4.6 2.0 2.6
Administration 2.4 0.8 1.6
Warehousing 2.4 1.0 1.4
Bad-debts 0.4 – 0.4
Collection 0.2 – 0.2
A study of credit files indicated that the collection period on ‗slow-paying‘ accounts average to 50 days versus 35 days for all accounts. The balance of debtors for these accounts averaged Rs 885,000 during 2004.
Should the Electro Limited tighten its credit policy? Make suitable assumptions.
9. The PQR Company‘s annual credit sales are Rs 60 crore. The company‘s existing credit terms are 1/15, net 40. Generally 60 per cent of the customers avail the cash discount facility. The average collection period is 45 days. The percentage default rate is 0.5 per cent. The company is thinking of two alternative changes in credit terms:
Percentage Taking Collection Default Credit Terms Discount Period Percentage
2/10, net 35 80 20 1.0
3/10, net 25 95 14 1.5
What strategy should be followed by PQR if sales are expected to remain stable and the required rate of return is 18 per cent?
10. Bansali Textiles Limited has annual sales of Rs 200 crore. It sells 80 per cent of its products on a 60-day credit. Its average collection period is 80 days. The company‘s bad debts, based on the past experience, could be estimated as 0.9 per cent of credit sales. The company‘s annual cost of administering credit sales is Rs 0.75 crore. It is possible to avoid Rs 0.20 crore of these costs if the company transfers credit administration to a factor. The factor will charge 1.75 per cent commission for his services. He can also extend advance against receivables to the company at an interest rate of 16.5 per cent after withholding 10 per cent as reserve. Should the company hire services of the factor?