bre44380_ch30_787-812.indd 794 10/06/15 10:57 AM
794 Part Nine Financial Planning and Working Capital Management
This is the correct decision if there is no chance of a repeat order. But look again at the
decision tree in Figure 30.5. If the customer does pay up, there will be a repeat order next year.
Because the customer has paid once, you can be 95% sure that he or she will pay again. For
this reason any repeat order is very profitable:Next year’s expected profit on repeat order = p 2 PV(REV − COST)
− (1 − p 2 ) PV(COST)
= (.95 × 200) − (.05 × 1,000) = $140Now you can reexamine today’s credit decision. If you grant credit today, you receive the
expected profit on the initial order plus the possible opportunity to extend credit next year:Total expected profit = expected profit on initial order
+ probability of payment and repeat order
× PV(next year’s expected profit on repeat order)
= −40 + .80 × PV(140)At any reasonable discount rate, you ought to extend credit. Notice that you should do so
even though you expect to take a loss on the initial order. The expected loss is more than
outweighed by the possibility that you will secure a reliable and regular customer. Cast Iron is
not committed to making further sales to the customer, but by extending credit today, it gains
a valuable option to do so. It will exercise this option only if the customer demonstrates its
creditworthiness by paying promptly.
Of course real-life situations are generally far more complex than our simple Cast Iron
examples. Customers are not all good or all bad. Many of them pay consistently late; you get
your money, but it costs more to collect and you lose a few months’ interest. Then there is
the uncertainty about repeat sales. There may be a good chance that the customer will give
you further business, but you can’t be sure of that and you don’t know for how long she will
continue to buy.
Like almost all financial decisions, credit allocation involves a strong dose of judgment.
Our examples are intended as reminders of the issues involved rather than as cookbook for-
mulas. Here are the basic things to remember.- Maximize profit. As credit manager, you should not focus on minimizing the number of
bad accounts; your job is to maximize expected profit. You must face up to the follow-
ing facts: The best that can happen is that the customer pays promptly; the worst is
default. In the best case, the firm receives the full additional revenues from the sale less
the additional costs; in the worst, it receives nothing and loses the costs. You must
weigh the chances of these alternative outcomes. If the margin of profit is high, you are
justified in a more liberal credit policy; if it is low, you cannot afford many bad debts.^9 - Concentrate on the dangerous accounts. You should not expend the same effort on
analyzing all credit applications. If an application is small or clear-cut, your deci-
sion should be largely routine; if it is large or doubtful, you may do better to move
straight to a detailed credit appraisal. Most credit managers don’t make decisions on an
order-by-order basis. Instead, they set a credit limit for each customer. The sales repre-
sentative is required to refer the order for approval only if the customer exceeds this limit. - Look beyond the immediate order. The credit decision is a dynamic problem. You can-
not look only at the present. Sometimes it may be worth accepting a relatively poor risk
(^9) Look back at our first Cast Iron example, where we concluded that the company is justified in granting credit if the probability of
collection is greater than 5/6. If the customer pays, Cast Iron will earn a profit margin of 200/1200 = 1/6. In other words, the company
is justified in granting credit if the probability of payment exceeds 1 − profit margin.