Introduction to Corporate Finance

ONLINE CHAPTERS

■ Relaxing credit standards will generally yield increased unit sales and additional profits. The additional

profit from relaxed credit standards assumes that each unit is sold at a positive contribution margin.

The contribution margin is a product’s price per unit minus variable costs per unit, and thus is a direct

measure of gross profit per unit sold. Relaxing credit standards will also yield higher costs from

additional investment in accounts receivable and additional bad debt expense.

■ Tightening credit standards will generally yield reduced investment in accounts receivable and lower

bad debt expense at the cost of lower sales and profits.

It is easiest to demonstrate how to calculate the net effect of changing credit standards by giving an

example.

example

Yunanderah Manufacturing Company (YMC) produces and sells a DVD organiser to video rental and sales

stores within Australia. YMC charges $20/unit, and all of its sales are on credit, with customers selected for

credit on the basis of a scoring process. With its existing credit standards, Yunanderah expects to sell 120,000

units over the coming year, yielding total sales of $2,400,000 (120,000 units × $20/unit). Variable costs are $12/

unit, and Yunanderah has fixed costs of $240,000 per year.

YMC is contemplating a relaxation of its credit standards, expecting the following effects: a 5% increase

in sales to 126,000 units; an increase in the average collection period from 30 days (the current level) to 45

days; and an increase in bad debt expense from 1% (the current level) to 2% of sales. YMC plans to keep the

product’s sale price unchanged at $20/unit, which implies that total sales will increase to $2,520,000 (126,000

units × $20/unit). If the company’s required return on investments of equal risk is 12%, should Yunanderah relax

its credit standards?

To make this decision, YMC’s managers must calculate: (1) how much profits will increase from the

additional sales that relaxed credit standards are expected to generate; (2) the cost of the marginal investment

in accounts receivable; (3) the cost of marginal bad debts; and (4) whether the financial benefits exceed the

costs. (Note: In this and subsequent accounts receivable policy change calculations, we use a single-period

approach rather than specifying all subsequent cash flows and determining their present value. Prior research

has shown that for the A/R decisions demonstrated in this chapter, the single-period model yields the same

accept-or-reject decision as a more detailed present value approach. We therefore choose to keep it simple.)

1 Marginal profit contribution from sales. We are assuming that a 5% increase in sales volume will not cause

YMC’s fixed costs to increase. Thus, we need to account only for changes in revenues and variable costs.

Specifically, we can compute the marginal increase in profits as the increased unit sales volume times the

contribution margin per unit sold:

Eq. 18.3 Marginal profit from increased sales = ∆Sales × CM

= ∆Sales × (Price – VC)

where

∆ Sales = change in unit sales resulting from the change in credit policies

CM = contribution margin

Price = price per unit

VC = variable cost per unit

With the assumptions just detailed for Yunanderah, we can use Equation 18.3 to determine that relaxing

credit standards as suggested will yield a marginal profit of $48,000:

Marginal profit from increased sales = 6,000 units × ($20/unit – $12/unit)

= 6,000 units × ($8/unit) = $48,000

2 Cost of the marginal investment in accounts receivable. To determine the cost of the marginal investment

in accounts receivable, we must calculate the cost of financing the current level of accounts receivable and

compare it to the expected cost under the new credit standards. This is more complicated than it sounds.

We must first calculate how much YMC currently has invested in accounts receivable based on its current

contribution margin
The sale price per unit minus
total variable cost per unit