Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VII. Short−Term Financial

Planning and Management

21. Credit and Inventory
    Management

© The McGraw−Hill^743

Companies, 2002

A Break-Even Application Based on our discussion thus far, the key variable for Lo-

cust is Q 
 Q, the increase in unit sales. The projected increase of 10 units is only an

estimate, so there is some forecasting risk. Under the circumstances, it’s natural to won-

der what increase in unit sales is necessary to break even.

Earlier, the NPV of the switch was defined as:

NPV
[PQv(Q 
 Q)] [(P
 v)(Q 
 Q)]/R

We can calculate the break-even point explicitly by setting the NPV equal to zero and

solving for (Q 
 Q):

NPV 0 
[PQv(Q 
 Q)] [(P
 v)(Q 
 Q)]/R

Q 
 QPQ/[(P
 v)/R
 v]

[21.7]

For Locust, the break-even sales increase is thus:

Q 
 Q$4,900/(29/.02
 20)

3.43 units

This tells us that the switch is a good idea as long as Locust is confident that it can sell

at least 3.43 more units per month.

OPTIMAL CREDIT POLICY

So far, we’ve discussed how to compute net present values for a switch in credit policy.

We have not discussed the optimal amount of credit or the optimal credit policy. In prin-

ciple, the optimal amount of credit is determined by the point at which the incremental

cash flows from increased sales are exactly equal to the incremental costs of carrying

the increase in investment in accounts receivable.

The Total Credit Cost Curve

The trade-off between granting credit and not granting credit isn’t hard to identify, but it is

difficult to quantify precisely. As a result, we can only describe an optimal credit policy.

To begin, the carrying costs associated with granting credit come in three forms:

1. The required return on receivables


2. The losses from bad debts


3. The costs of managing credit and credit collections
   We have already discussed the first and second of these. The third cost, the cost of man-
   aging credit, consists of the expenses associated with running the credit department.
   Firms that don’t grant credit have no such department and no such expense. These three
   costs will all increase as credit policy is relaxed.
   If a firm has a very restrictive credit policy, then all of the associated costs will be
   low. In this case, the firm will have a “shortage” of credit, so there will be an opportu-
   nity cost. This opportunity cost is the extra potential profit from credit sales that is lost

CONCEPT QUESTIONS

21.3a What are the important effects to consider in a decision to offer credit?

21.3bExplain how to estimate the NPV of a credit policy switch.

716 PART SEVEN Short-Term Financial Planning and Management

21.4

For business reports on
credit visit
http://www.creditworthy.com.