Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVII. Short−Term Financial
Planning and Management- Credit and Inventory
Management
© The McGraw−Hill^741
Companies, 20023.The cost of debt.When the firm grants credit, it must arrange to finance the
resulting receivables. As a result, the firm’s cost of short-term borrowing is a factor
in the decision to grant credit.^2
4.The probability of nonpayment.If the firm grants credit, some percentage of the
credit buyers will not pay. This can’t happen, of course, if the firm sells for cash.
5.The 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 suc-
cessful firms that develop computer programs. Currently, Locust sells for cash only.
Locust is evaluating a request from some major customers to change its current pol-
icy 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
Q Quantity sold under new policy
R Monthly required return
For now, we ignore discounts and the possibility of default. Also, we ignore taxes be-
cause they don’t affect our conclusions.NPV of Switching Policies To illustrate the NPV of switching credit policies, sup-
pose we have the following for Locust:
P$49
v$20
Q 100
Q 110
If the required return, R,is 2 percent per month, should Locust make the switch?
Currently, Locust has monthly sales of PQ$4,900. Variable costs each month
are vQ$2,000, so the monthly cash flow from this activity is:
Cash flow with old policy (P v)Q [21.2]
($49 20) 100
$2,900
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.714 PART SEVEN Short-Term Financial Planning and Management
(^2) The cost of short-term debt is not necessarily the required return on receivables, although it is commonly
assumed to be. As always, the required return on an investment depends on the risk of the investment, not
the source of the financing. The buyer’s cost of short-term debt is closer in spirit to the correct rate. We will
maintain the implicit assumption that the seller and the buyer have the same short-term debt cost. In any
case, the time periods in credit decisions are relatively short, so a relatively small error in the discount rate
will not have a large effect on our estimated NPV.