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F 2. Between firms, trade credit occurs when one firm buys goods or services from
another with simultaneous payment. (FALSE: Should be without simultaneous instead of with
simultaneous.)
T 3. Consumer credit, or retail credit, is created when a firm sells goods or services to
a consumer without simultaneous payment.
F 5. Suppliers do not know how to handle the goods as collateral better than other
lenders such as banks. (FALSE: Should be know how instead of do not know how.)
F 6. A supplier generally has poorer information than the customer about the quality
of its products. (FALSE: Should be better instead of poorer.)
T 8. By granting credit to the ultimate buyer, the payments mechanism bypasses all of
the agents in the distribution process, requiring only one payment from the ultimate buyer to the
original seller.
T 10. Convenience and safety are important for both business and retail customers, but
psychology is also important, especially at the retail level.
F 12. A more liberal credit policy should decrease the cost of goods sold and increase
the gross profit, bad debt expenses, the cost of carrying additional receivables, and administrative
costs. (FALSE: Should be increase the cost of goods sold instead of decrease the cost of goods
sold.)
T 13. Depending on the industry, credit policy can vary from being crucial to being
irrelevant.
T 14. Credit terms are the contract between the supplier and credit customer specifying
how the credit will be repaid.
T 15. The invoice is a written statement about goods that were ordered, along with their
prices and the payment dates.
F 16. When a firm is using invoice billing, the invoice that accompanies shipment is an
additional bill to be paid. (FALSE: Should be a separate bill instead of an additional bill.)
T 17. A firm can protect itself from uncertainty by maintaining safety stocks–that is, a
buffer inventory.
F 18. CIA stands for cash in addition and CBD stands for cash before delivery.
(FALSE: Should be cash in advance instead of cash in addition.)
T 19. Unlike COD, cash terms allow the customer to mail the payment.
T 20. Although seasonal dating does give buyers a longer time to pay, sellers benefit by
encouraging buyers to make earlier purchase decisions.
a 26. Most credit sales are made on an open account basis, which means .
a. that customers simply purchase what they want.
b. that suppliers dictate the terms of the purchase.
c. that customers cannot simply purchase what they want.
d. that suppliers cannot dictate the terms of the purchase.
d 31. says to calculate the incremental cash flows for receivables and
inventory decisions.
a. The Principle of Risk-Return Trade-off
b. The Principle of Capital Market Efficiency
c. The Principle of Diversification
d. The Principle of Incremental Benefits
a 44. says to use common industry practices provide a starting place for
operating efficiently.
a. The Behavioral Principle
b. The Principle of Incremental Benefits
c. The Principle of Self-Interested Behavior
d. The Principle of Valuable Ideas
b 47. When terms specified in the letter of credit are met, such as delivery of the
goods, the bank will make payment .
a. to the customer.
b. on behalf of the customer.
c. on behalf of the supplier.
d. none of these
a 51. Silver, Inc. has a customer who wants to purchase $35,500 of goods on credit.
Silver estimates that the customer has a 97% probability of paying the $35,500 in 2 months and a
3% probability of a complete default (paying no cash at all). Assume an investment of 90% of the
amount, made at the time of the sale, and a required return of 10% APY. What is the credit sale?
a. $31,950
b. $32,050
c. $32,450
d. $33.500
[ANSWER: The credit sale is: C = 0.9(R) = 0.9($35,500) = $31,950.]
c 52. Maxwell Corporation has a customer who wants to purchase $50,000 of goods on
credit. Maxwell estimates that the customer has a 97% probability of paying the $50,000 in 4
months and a 3% probability of a complete default (paying no cash at all). Assume an investment
of 85% of the amount, made at the time of the sale, and a required return of 10% APY. What is
the NPV of granting credit?
a. about $4,580.00
b. about $4,500.37
c. about $4,483.37
d. about $4,464.00
[ANSWER: The credit sale is: C = 0.85(R) = 0.85($50,000) = $42,500. We use the formula: NPV
= [p(R) / (1 + r)t] – C. Inserting our values, we have: NPV = [0.97($50,000) / (1 + 0.10) 1/3] –
$42,500 = [$48,500 / 1.0322801] – $42,500 = $46,983.372 – $42,500 = $4,483.3715 or about
$4,483.37.]
c 53. Maxwell Corporation has a customer who wants to purchase $50,000 of goods on
credit. Maxwell estimates that the customer has a 97% probability of paying the $50,000 in 4
months and a 3% probability of a complete default (paying no cash at all). Assume an investment
of 85% of the amount, made at the time of the sale, and a required return of 10% APY. What is
the indifference payment probability (p*)?
a. about 87.01%
b. about 87.33%
c. about 87.75%
d. about 87.99%
[ANSWER: To find p*, we must compute C and NPV. The credit sale is: C = 0.85(R) =
0.85($50,000) = $42,500. The net present value is: NPV = [p(R) / (1 + r) t] – C =
[0.97($50,000) / (1 + 0.10)1/3] – $42,500 = [$48,500 / 1.0322801] – $42,500 = $46,983.372 –
$42,500 = $4,483.3715 or about $4,483.37. We use the formula: p* = C(1 + r) t / R. Inserting our
values, we have: p* = $42,500(1 + 0.10)1/3 / $50,000 = $42,500(1.0322801) / $50,000 =
$43,871.905 / $50,000 = 0.8774381 or about 87.75%.]
a 54. Maxwell Corporation has a customer who wants to purchase $50,000 of goods on
credit. Maxwell estimates that the customer has a 97% probability of paying the $50,000 in 4
months and a 3% probability of a complete default (paying no cash at all). Maxwell assumes an
investment of 85% of the amount, made at the time of the sale, and a required return of 10% APY.
Based on these numbers Maxwell estimates the NPV to be $4,483.37. What if Maxwell is wrong
and it takes the customer 6 months to pay. Will the NPV still be positive?
a. Yes, the NPV will be about $3,742.94.
b. Yes, the NPV will be about $4,742.94.
c. Yes, the NPV will be greater than $4,742.94.
d. No, the NPV will be negative.
[ANSWER: The credit sale is: C = 0.85(R) = 0.85($50,000) = $42,500. We use the formula: NPV
= [p(R) / (1 + r)t] – C. Inserting our values, we have: NPV = [0.97($50,000) / (1 + 0.10) 0.5] –
$42,500 = [$48,500 / 1.0488088] – $42,500 = $46,242.936 – $42,500 = $3,742.9356 or about
$3,742.94. Thus, NPV is still positive.]
d 55. Silver Corporation has a customer who wants to purchase $50,000 of goods on
credit. Silver estimates that the customer has a 97% probability of paying the $50,000 in 4
months and a 3% probability of a complete default (paying no cash at all). Silver assumes an
investment of 85% of the amount, made at the time of the sale, and a required return of 10% APY.
Based on these numbers Silver estimates the NPV to be $4,483.37. What if Silver is wrong and
the customer has a 13% probability of default. Will the NPV still be positive?
a. Yes, the NPV will be positive.
b. We cannot tell.
c. We are indifferent because the NPV is zero and p* is 87%.
d. No, the NPV will be negative.
[ANSWER: The credit sale is: C = 0.85(R) = 0.85($50,000) = $42,500. We use the formula: NPV
= [p(R) / (1 + r)t] – C. Inserting our values, we have: NPV = [0.87($50,000) / (1 + 0.10) 1/3] –
$42,500 = [$43,500 / 1.0322801] – $42,500 = $42,139.725 – $42,500 = –$360.27505 or
about –$360.28. Thus, the NPV will be negative.]
d 56. In the original month (t), you collect 20% of your sales. In month t + 1, you
collect 40% of your sales. In month t + 2, you collect 30%. In month t + 4, you collect 10%.
January is your original month. Which of the following statements is true?
a. The balance fraction for March is 0.6.
b. The balance fraction for month t + 2 is 0.9.
c. The collection fraction in March is greater than any other collection fraction.
d. The balance fraction for April is 0.
[ANSWER: The collection fraction in the original month (January) is 0.2. For month t + 1
(February), it is 0.4. For month t + 2 (March), it is 0.3. For month t + 3 (April), it is 0.1. The
collection fraction for month t + 1 (February) is the greatest fraction. The balance fraction for
each month is 1 – (the sum of the collection fractions for the current month back to the original
month). Thus, for month t + 2 (March) the balance fraction is 1 – (0.2 + 0.4 + 0.3) = 1 – 0.9 =
0.1. For month t + 3 (April), the balance fraction is 1 – (02. + 0.4 + 0.3 + 0.1) = 1 – 1 = 0.]
a 57. Your receivables in December from the previous month are $11,920. The
collections in January from the two previous months are $10,320. What are your receivables in
January for the two previous months?
a. $1,600
b. $10,320.
c. $11,920
d. cannot tell
[ANSWER: Receivables in January from two months previous = receivables in December from
the previous month – collections in January from two months previous = $11,920 – $10,320 =
$1,600.]
b 58. A firm currently uses credit terms of net 35 with no discounts allowed. It has
sales of $2M (M = million), cost of sales (at t = 0) of $1.3M. On average, 97% of customers pay
in 2 months, while 3% of customers never pay. At a required return of 1% per month, what is the
NPV of one year’s sales under the current policy?
a. about $611,380
b. about $621,380
c. about $631,380
d. about $641,380
[ANSWER: The current policy requires a $1.3M outflow at t = 0 and has an expected inflow in 2
months of $2M minus 2% in bad debt losses from customers who never pay. Thus, the NPV of
one year’s sales under the current policy is: NPV (current policy) =
[(1 – 0.02)($2M) / (1 + 0.01)2] – $1.3M = [$1.96M / (1.01)2] – $1.3M = $1,921,380.26 –
$1,300,000 = $621,380.26 or about $621,380.]
c 59. A firm currently uses credit terms of net 30 with no discounts allowed. Current
sales are $1M (M = million) with $0.6M in cost of goods sold. It is considering a switch to 2/10,
net 30. The proposed policy results in a 5% increase in sales and cost of goods sold. On average,
70% of customers pay early and take the 2% discount. The balance of the customers who pay,
29% of sales, pay in 1.5 months. What is the NPV of the proposed policy?
a. about $336,714
b. about $356,714
c. about $386,714
d. none of these
[ANSWER: Sales increase (1 + 0.05)$1M = $1.05M, while costs of goods sold increase to
(1 + 0.05)($0.6M) = $0.63M at t = 0. On average, 70% of customers pay early and take the 2%
discount, resulting in a cash flow of 0.7(1 – 0.02)($1.05M) = $720,300 in 0.5 months. The
balance of the customers who pay, 29% of sales, pay in 1.5 months. These customers pay
0.29($1.05M) = $304,500. So the NPV of one year's sales for the proposed policy is:
NPV(proposed policy) = [0.7(1 – 0.2)(1 + 0.05)($1M) / (1 + 0.01)0.5] + [0.29(1 + 0.05)($1M) / (1.01)1.5] –
[(1 + 0.05)$0.6M] = [0.7(0.98)(1.05)($1M) / (1.01) 0.5] + [0.29(1.05)($1M) / (1.01)1.5] –
[(1.05)$0.6M] = [$720,300 / 1.00498756] + [$304,500 / 1.01503744] – [$0.63M] =
$716,725.2881 + $299,988.9351 – $630,000 = $386,714.2232 or about $386,714.]
b 60. Suppose Office Supply Corporation sells personal copying machines at the rate
of 900 units per year. The cost of placing one order is $225, and it costs $50 per year to carry a
copier in inventory. What is Office Supply’s EOQ?
a. about 88 copiers.
b. about 90 copiers.
c. about 92 copiers.
d. about 94 copiers.
[ANSWER: Using the EOQ formula, we have: EOQ = [2(F)S / C]0.5 = [2($225)900 / $50]0.5 =
[8,100]0.5 = 90 copiers.]
d 61. Suppose Office Supply Corporation sells personal copying machines at the rate
of 900 units per year. The cost of placing one order is $225, and it costs $50 per year to carry a
copier in inventory. Which of the below statements is false?
a. The number of orders per year is 10 and the time interval between orders is 36.5
days.
b. The annual ordering cost and the annual carrying cost are both $2,250.
c. The average inventory is 45 copiers and the total annual cost is $4,500.
d. all of these
[ANSWER: EOQ = [2(F)S / C]0.5 = [2($225)900 / $50]0.5 = [8,100]0.5 = 90 copiers. Average
inventory = EOQ/2 = 90/2 = 45 copiers. Number of orders per year = S/EOQ = 900/90= 10 times
per year. Time interval between orders = EOQ/S = 90/900 = 0.1 years or (0.1)365 = 36.5 days.
Annual ordering cost = F(S/EOQ)= $225(900/90) = $225(10) = $2,250. Annual carrying cost =
C(EOQ/2) = $50(90/2) = $50(45) = $2,250. Office Supply’s total annual cost is: Total cost =
Ordering cost + Carrying cost = F(S / EOQ) + C(EOQ / 2) = $225(900 / 90) + $50(90 / 2) =
$2,250 + $2,250 = $4,500.]
c 62. Suppose Office Supply Corporation sells personal copying machines at the rate
of 900 units per year. The cost of placing one order is $225, and it costs $50 per year to carry a
copier in inventory. Office Supply’s EOQ is 90. The dealer now offers a quantity discount of $1
per unit for orders of 150 or more. Should Office Supply order 150 each time to get the discount?
a. No, the costs are now greater.
b. Yes, the costs have decreased by $100.
c. Yes, the costs have decreased by $300.
d. Yes, the costs have decreased by $600.
[ANSWER: Total cost = Ordering cost + Carrying cost = F(S / EOQ) + C(EOQ / 2) =
$225(900 / 90) + $50(90 / 2) = $2,250 + $2,250 = $4,500. Office Supply must compare the total
cost of ordering the larger quantity to get the discount with the total costs of ordering the EOQ.
We calculated the total cost using the EOQ to be $4,500. To incorporate the price discount
component in our equation, we use: Total cost = Ordering cost + Carrying cost – Price discounts
= F(S / EOQ) + C(EOQ / 2) – dS where d is the dollar price discount per unit. Inserting our
values, we have: Total cost = $225(900 / 150) + $50(150 / 2) – $1(900) = $1,350 + $3,750 – $900
=
$5,100 – $900 = $4,200. The total cost of ordering 150 units each time is $3,300. The order size
of 150 increases the inventory costs from $4,500 to $5,100 per year. The firm receives discounts
of $1.00 per unit on the entire year’s purchases (900 units). The total discounts received ($900)
are more than the $5,100 – $4,500 = $600 increase in ordering and carrying costs. The total costs
decline by $900 – $600 = $300 when the quantity discount is taken. Thus raising the order size to
150 is worth it.]
c 63. Oxford Arms sells bullet-proof vests through mail orders. Oxford sells 5,000
vests per year, with a fixed cost of $60 per order, and a carrying cost of $15 per unit average
inventory. Oxford’s EOQ is 200 vests. This order quantity implies S/Q = 5,000 / 200 = 25 orders
per year and an ordering cost of (S / Q)F = $25(60) = $1,500 per year. .Adding the first 15 units
to the safety stock reduces the expected stockout cost by $500. How much do Oxford’s total costs
decrease by adding 5 units of safety stock?
a. $500
b. $400
c. $275
d. $225
[ANSWER: The annual carrying cost of the 15 units of safety stock is 15($15) = $225. So the
total cost declines by $500 – $225 = $275.]
b 64. In the original month (t), you collect 20% of your sales. In month t + 1, you
collect 40% of your sales. In month t + 2, you collect 30%. In month t + 4, you collect 10%.
January is your original month. Which of the following statements is true?
a. The balance fraction for March is 0.6.
b. The collection fraction for month t + 1 is 0.4.
c. The collection fraction in January is greater than any other collection fraction.
d. The balance fraction for April is 1.
[ANSWER: The collection fraction in the original month (January) is 0.2. For month t + 1
(February), it is 0.4. For month t + 2 (March), it is 0.3. For month t + 3 (April), it is 0.1. The
collection fraction for month t + 1 (February) is the greatest fraction. The balance fraction for
each month is 1 – (the sum of the collection fractions for the current month back to the original
month). Thus, for month t + 2 (March) the balance fraction is 1 – (0.2 + 0.4 + 0.3) = 1 – 0.9 =
0.1. For month t + 3 (April), the balance fraction is 1 – (02. + 0.4 + 0.3 + 0.1) = 1 – 1 = 0.]
d 65. A firm currently uses credit terms of net 30. It is considering a switch to 2/10, net
30. The expected effects of this more liberal policy are:
Current policy Proposed Policy .
Credit terms net 30 2/10, net 30
Sales (M = millions) $1M $1.05M
Cost of sales (at t = 0) $0.6M $0.63M
Bad debt losses 1.5% of sale 1.0% of sales
0.015($1M) = $15,000 0.01($1.05M) = $10,500
Collection pattern 1.5 months 0.5 months (70%)
(98.5% pay) 1.5 months (29%)
(1.5% never pay) (1% never pays)
Required return 1% per month 1% per month
Sales less bad debt $1M – $0.015M $1.05M – 0.01($1.05M)
= $985,000 = $1,039,500
Discounts taken $0 0.02(0.70)($1.05M) = $14,700
Sales – bad debt – discounts $1M – $0.015M – 0 $1.05M – $0.0105M – $0.0147M
= $985,000 = $1,024,800 .
Which of the below statements is false?
a. At a required return of 1% per month, the NPV of one year’s sales under the
current policy is: NPV (current policy) = [(1 – 0.15)($1M) / (1 + 0.01) 1.5] – $0.6M =
[$0.985M / (1.01)1.5] – $0.6M = $970,408– $600,000 = $370,408.
b. NPV (proposed policy) = [0.7(1 – 0.02)(1 + 0.05)$1M / (1 + 0.01) 0.5] +
[0.29(1 + 0.05)$M) / (1 + 0.01)1.5] – $0.63M = $716,725 + $299,989 – $630,000 = $386,714.
c. Because the proposed policy has the greater NPV ($386,714 versus $370,408),
the firm would be better off with the proposed change in credit policy.
d. all of these
[ANSWER: At a required return of 1% per month, the NPV of one year’s sales under the current
policy is: NPV (current policy) = [(1 – 0.15)($1M) / (1 + 0.01) 1.5] – $0.6M = [$0.985M / (1.01)1.5]
– $0.6M = $970,408– $600,000 = $370,408. NPV (proposed policy) = [0.7(1 – 0.02)(1 +
0.05)$1M / (1 + 0.01)0.5] + [0.29(1 + 0.05)$M) / (1 + 0.01)1.5] – $0.63M = $716,725 + $299,989 –
$630,000 = $386,714. Because the proposed policy has the greater NPV ($386,714 versus
$370,408), the firm would be better off with the proposed change in credit policy.]
a 66. A firm currently uses credit terms of net 30 with no discounts allowed. Current
sales are $2M (M = million) with $1.2M in cost of goods sold. It is considering a switch to 2/10,
net 30. The proposed policy results in a 5% increase in sales and cost of goods sold. On average,
70% of customers pay early and take the 2% discount. The balance of the customers who pay,
29% of sales, pay in 1.5 months. What is the NPV of the proposed policy?
a. about $773,428
b. about $793,428
c. about $873,428
d. none of these
[ANSWER: Sales increase (1 + 0.05)$2M = $2.1M, while costs of goods sold increase to
(1 + 0.05)($1.2) = $1.26M at t = 0. On average, 70% of customers pay early and take the 2%
discount, resulting in a cash flow of 0.7(1 – 0.02)($2.1M) = $1,440,600 in 0.5 months. The
balance of the customers who pay, 29% of sales, pay in 1.5 months. These customers pay
0.29($2.1M) = $609,000. So the NPV of one year's sales for the proposed policy is:
NPV(proposed policy) = [0.7(1 – 0.2)(1 + 0.05)($2M) / (1 + 0.01)0.5] + [0.29(1 + 0.05)($2M) / (1.01)1.5] –
[(1 + 0.05)$1.2M] = [0.7(0.98)(1.05)($2M) / (1.01) 0.5] + [0.29(1.05)($2M) / (1.01)1.5] –
[(1.05)$1.2M] = [$1,440,600 / 1.00498756] + [$609,000 / 1.01503744] – [$1.26M] =
$1,433,450.5762 + $$599,977.8701 – $1,260,000 = $773,428.4464or about $773,428.45.]
b 67. A firm currently uses credit terms of net 30 with no discounts allowed. It has
sales of $1M (M = million), cost of sales (at t = 0) of $0.6M. On average, 98.5% of customers pay
in 1.5 months, while 1.5% of customers never pay. Its required rate of return is 1% per month.
What is the NPV of one year’s sales under the current policy?
a. about $385,000
b. about $370,407
c. about $350,000
d. about $340,511
[ANSWER: The current policy requires a $0.6M outflow at t = 0 and has an expected inflow in
1.5 months of $1M minus 1.5% in bad debt losses from those customers who do not pay. Thus,
the NPV of one year’s sales under the current policy is: NPV (current policy) =
[(1 – 0.015)($1M) / (1 + 0.01)1.5] – $0.6M = [$0.985M / (1.01)1.5] – $0.6M = $970,407.56 –
$600,000 = $370,407.56 or about $370,407.]
c 68. 57. Your receivables in June from the previous month are $22,920. The
collections in July from the two previous months are $20,320. What are your receivables in July
for the two previous months?
a. $2,400
b. $2,500
c. $2,600
d. $2,700
[ANSWER: Receivables in July from two months previous = receivables in June from the
previous month – collections in July from two months previous = $22,920 – $20,320 = $2,600.]
c 69. In the original month (t), you collect 20% of your sales. In month t + 1, you
collect 40% of your sales. In month t + 2, you collect 30%. In month t + 4, you collect 10%.
January is your original month. Which of the following statements is true?
a. The balance fraction for March is 0.4.
b. The balance fraction for month t + 2 is 0.9.
c. The collection fraction in February is greater than any other collection fraction.
d. The balance fraction for April is 0.1.
[ANSWER: The collection fraction in the original month (January) is 0.2. For month t + 1
(February), it is 0.4. For month t + 2 (March), it is 0.3. For month t + 3 (April), it is 0.1. The
collection fraction for month t + 1 (February) is the greatest fraction. The balance fraction for
each month is 1 – (the sum of the collection fractions for the current month back to the original
month). Thus, for month t + 2 (March) the balance fraction is 1 – (0.2 + 0.4 + 0.3) = 1 – 0.9 =
0.1. For month t + 3 (April), the balance fraction is 1 – (02. + 0.4 + 0.3 + 0.1) = 1 – 1 = 0.]
70. Maxwell Corporation has a customer who wants to purchase $50,000 of goods on credit.
Maxwell estimates that the customer has a 97% probability of paying the $50,000 in 3 months
and a 3% probability of a complete default (paying no cash at all). Assume an investment of 85%
of the amount, made at the time of the sale, and a required return of 10% APY. Answer the below
questions.
(1) Describe the formula used to determine the net present value of a credit granting
decision.
(2) What is the credit sale? What is the NPV of granting credit?
(3) Describe the formula used to determine an indifference (zero-NPV) payment
probability, p*.
(4) What is the indifference payment probability?
ANSWER (1): NPV = [p(R) / (1 + r)t] – C where p is the probability of payment, R is the sale
amount, r is the APR, t is the time the payment is expected, and C is the credit sale. At time zero,
we invest C in a credit sale. The investment might be the cost of goods sold and sales
commissions. The expected payment is pR. The customer’s probability of payment is estimated
subjectively or with the help of statistical models. If the NPV is negative, then credit should not
be granted. Of course, we would like a positive NPV.
ANSWER (2): The credit sale is: C = 0.85(R) = 0.85($50,000) = $42,500. We use the formula:
NPV = [p(R) / (1 + r)t] – C. Inserting our values, we have: NPV = [0.97($50,000) / (1 + 0.10) 0.25]
– $42,500 = [$48,500 / 1.0241137] – $42,500 = $47,358.023 – $42,500 = $4,858.0235 or about
$4,858.02.
ANSWER (3): The formula is p* = C(1 + r)t / R where p* is the payment probability that gives
NPV = 0, C is the credit sale, r is the APR, t is the time the payment is expected, and R is the sale
amount. If a credit customer has a payment probability exceeding p*, then granting credit has a
positive NPV. This indifference payment probability is found by setting the equation for NPV (of
granting credit) equal to zero and then solving for p.
ANSWER (4): We use the formula: p* = C(1 + r)t / R. Inserting our values, we have: p* =
$42,500(1 + 0.10)0.25 / $50,000 = $42,500(1.0241137) / $50,000 = $43,524.832 / $50,000 =
0.8704966 or about 87.05%.
71. Girl Scouts of America (GSA) has a customer who wants to purchase $1,000 of goods on
credit. GSA estimates that the customer has a 95% probability of paying the $1,000 in 3 months
and a 5% probability of a complete default (paying no cash at all). Assume an investment of 80%
of the amount, made at the time of the sale, and a required return of 20% APY. Answer the below
questions.
(1) Describe the formula used to determine the net present value of a credit granting
decision.
(2) What is the credit sale? What is the NPV of granting credit?
(3) Describe the formula used to determine an indifference (zero-NPV) payment
probability, p*.
(4) What is the indifference payment probability?
ANSWER (1): NPV = [p(R) / (1 + r)t] – C where p is the probability of payment, R is the sale
amount, r is the APR, t is the time the payment is expected, and C is the credit sale. At time zero,
we invest C in a credit sale. The investment might be the cost of goods sold and sales
commissions. The expected payment is pR. The customer’s probability of payment is estimated
subjectively or with the help of statistical models. If the NPV is negative, then credit should not
be granted. Of course, we would like a positive NPV.
ANSWER (2): The credit sale is: C = 0.8(R) = 0.8($1,000) = $800. We use the formula: NPV =
[p(R) / (1 + r)t] – C. Inserting our values, we have: NPV = [0.95($1,000) / (1 + 0.20) 0.25] – $800 =
[$950 / 1.0466351] – $800 = $907.67065 – $800 = $107.67065 or about $107.67.
ANSWER (3): The formula is p* = C(1 + r)t / R where p* is the payment probability that gives
NPV = 0, C is the credit sale, r is the APR, t is the time the payment is expected, and R is the sale
amount. If a credit customer has a payment probability exceeding p*, then granting credit has a
positive NPV. This indifference payment probability is found by setting the equation for NPV (of
granting credit) equal to zero and then solving for p.
ANSWER (4): We use the formula: p* = C(1 + r)t / R. Inserting our values, we have: p* = $800(1
+ 0.2)0.25 / $1,000 = $800(1.0466351) / $1,000 = $837.30811 / $1,000 = 0.8373081 or about
83.73%.
72. Acme Corporation uses a scoring model where a score of 25 gives an expected NPV of
zero. Acme is considering two customer’s creditworthiness. Acme’s scoring model along with the
two customers characteristics are given below.
Four Financial Variables: Customer 1 Customer 2
X1 = net working capital/sales (%) 15% 8%
X2 = debt/assets (%) 40% 40%
X3 = assets/sales (%) 80% 90%
X4 = net profit margin (%) 12% 9% .
Answer the below questions given the above characteristics.
(1) Assessing a firm’s ability to pay its debts is a complex judgment, because many
factors affect creditworthiness. One tool many firms use is credit scoring. Describe this tool using
Acme’ model.
(2) What is customer 1’s credit score?
(3) What is customer 2’s credit score?
(4) Should either of these two customers be granted credit? What cautions should Acme
use in applying any scoring model?
ANSWER (1): Credit scoring combines several financial variables into a single score, or index,
that measures creditworthiness. The score is often a linear combination of several specific
variables. A score (S) based on Acme’s four financial variables would be given by:
S = w1X1 + w2X2 + w3X3 + w4X3 = 2X1 – 0.3X2 + 0.1X3 + 0.6X4 where X1 = net working
capital/sales (expressed as a percent), X 2 = debt/assets (%), X3 = assets/sales (%), and X4 = net
profit margin (%). The w's are the coefficients (or weights) that are multiplied by the X's
(financial characteristics) to create the overall credit score. The positive coefficients for X 1, X3,
and X4 mean that a higher value results in a higher credit score. The negative coefficient for X 2
means that a higher debt/assets ratio reduces the credit score.
ANSWER (2): Using our credit score equation for customer 1 and inserting this customer’s
characteristics, we have: Scustomer 1 = w1X1 – w2X2 + w3X3 + w4X4 = 2X1 – 0.3X2 + 0.1X3 + 0.6X4 =
2.0(15%) – 0.3(40%) + 0.1(80%) + 0.6(12%) = 30% – 12% + 8% +7.2% = 33.20%. Thus,
customer 1's credit score 1 is 33.20%.
ANSWER (3): Using our credit score equation for customer 2 and inserting this customer’s
characteristics, we have: Scustomer 2 = w1X1 – w2X2 + w3X3 + w4X4 = 2X1 – 0.3X2 + 0.1X3 + 0.6X4 =
2.0(8%) – 0.3(40%) + 0.1(90%) + 0.6(9%) = 16% – 12% + 9% +5.4% = 18.40%. Customer 2's
credit score is 18.40%.
ANSWER (4): If the firm expects a zero NPV for customers with a score of 25%, customer 1
should get credit because (s)he scores higher than 25%. Customer 2 should be denied credit
because (s)he scores below 25%. Any model is only as good as the payment records used to
construct the models. Credit-scoring models work best when applied to large populations of loan
applicants. The number of business loans in a database is often too small to be statistically
reliable.
73. Suppose Mark Watts is applying for a credit card. After graduating with his college
degree, Mark has a new job earning $40,500 per year. Mark has just moved to his new job and
has rented an apartment. His telephone is connected, and he has a fair credit report. The cut-off to
qualify for a credit card is 15. Answer the below questions.
(1) Describe the scoring sheet for a credit card application.
(2) What is Mark’s credit score?
(3) Does Mark qualify for a credit car based on his score?
ANSWER (1): For a credit card application, the following scoring sheet (sometimes called a
weighted application blank) is often used. Telephone: Yes = 4 points; No = 0. Income: Above
$40,000 = 3 points; $20,000 – $40,000 = 2 points; below $20,000 = 0 points. Employment:
More than 3 years with current employer = 3 points; 1–3 years with current employer = 2 points;
less than 1 year with current employer = 1; Self-employed = 1 point; Unemployed = 0 points.
Residence: Own = 3 points; Rent = 1 point; more than 3 years at current address 2 points; 1–3
years at current address = 1 point; 0–1 years at current address = 0 points. Credit report: Good =
10 points; Fair = 4 points; Bad = –5 points; None = 0 points.
ANSWER (3): If the cutoff is 15 points, Mark fails to qualify for the credit card since his score is
only 13.
74. Cheddar Corporation’s working capital team is analyzing its aging schedule. Cheddar
finds the following:
AGE AMOUNT PERCENTAGE
0–30 Days $12,000 50.00%
30–60 Days $8,000 33.33%
60–90 Days $4,000 16.67%
Over 90 Days $0 0% .
Answer the below questions.
(1) Describe an aging schedule.
(2) What does an aging schedule depend on?
(3) In addition to an aging schedule, managers commonly compute an average age of
accounts receivable, the average age of all of the firm's outstanding invoices. Describe the two
common ways to make the computation.
(4) Using Cheddar’s aging schedule and the simplified method of computing the average
age of accounts receivable, what is Cheddar’s average age of accounts receivable?
(5) What does your average age calculation in (4) depend on?
ANSWER (1): An aging schedule is a table showing the total dollar amounts and the percentages
of total accounts receivable that fall into several age classifications. It provides a picture of the
quality of outstanding accounts receivable. Such schedules usually show those receivables that
are 0 to 30 days old, 30 to 60 days old, 60 to 90 days old, and over 90 days old. The percentage
breakdown can be readily compared to previous aging schedule breakdowns to see if the current
situation is different from past experience.
ANSWER (2): The aging schedule depends on the credit terms offered, customer payment habits,
and trends in recent sales. For example, if a firm changes its credit terms, such as giving
customers a longer credit period, the aging schedule will reflect this change. If customers are
paying more quickly, the percentage in the youngest categories will increase and the percentage
in the older categories will decrease. Likewise, a change in the firm’s sales can affect the aging
schedule. If sales increase during the current month, the percentage of 0 to 30 days receivables
will increase. Conversely, a sales decrease tends to reduce the percentage of 0 to 30 days
receivables.
ANSWER (3): The first is to calculate the weighted average age of all individual outstanding
invoices. The weights used are the percentages that the individual invoices represent out of the
total amount of accounts receivable. A simplified way to calculate the average age of accounts
receivable is to use the aging schedule. Here, all receivables that are 0 to 30 days old are assumed
to be 15 days old (the midpoint of 0 and 30), all receivables that are 30 to 60 days old are
assumed to be 45 days old, and all receivables that are 60 to 90 days old are assumed to be 75
days old. Then the average age is computed by taking a weighted average of 15, 30, and 45. The
weights are the percentages of receivables that are 0 to 30, 30 to 60, and 60 to 90 days old,
respectively.
ANSWER (4): Using Cheddar’s aging schedule, we first compute the midpoint for each
category. For the first category (0–30 days) the midpoint is 15 (X 1 = 15). For the second category
(30–60 days), the midpoint is 45 (X2 = 45). For the third (60–90 days) category, the midpoint is
75 (X3 = 75). The fourth category has no entries (weight is zero). Multiplying these midpoints by
their respective weights (representing their portion of the total), we have: Average age = w 1X1 –
w2X2 + w3X3 + w4X4 = 0.50 (15) + 0.3333(45) + 0.1667(75) + 0(X4) = 7.5 + 15 + 12.5 = 35 days.
We estimate that the weighted average age of accounts receivable is 35 days.
ANSWER (5): If depends on the same factors that affect an aging schedule, namely, changes in
credit terms, payment habits, or sales levels can increase or decrease the average age.
V. Short Answers
They are computer-based systems that plan backward from the production schedule to make
purchases and manage inventory levels.
It is credit granted by a business to another business for the purchase of goods or services.
It refers to a percent a customer can deduct from the net amount of the bill if payment is made
before the end of the discount period.
It is the written statement from a supplier about goods that were shipped along with the amount
due and the payment dates.
It is the date when goods are usually shipped. Payment dates are set relative to the invoice date.
It refers to the sales for a period such as a month (for which a customer also receives invoices).
All of the sales are collected into a single statement, and the customer must pay all of the invoices
represented on the statement.
It is a credit account where the customer makes purchases and the signed invoices are evidence of
indebtedness.
They are the five characteristics that are used to form a judgment about a customer's
creditworthiness. The five C's of credit are character, capacity, capital, collateral, and conditions.
It is a statistical technique where several financial characteristics are combined to form a single
score to represent a customer's creditworthiness.
It is a table showing the dollar amounts and the percentages of total accounts receivable that fall
into several age categories.
It is the percentage of a given month's sales collected during the month of sale and each month
following.
It is the percentage of a given month's sales that remain uncollected (and in accounts receivable)
at the end of the month of sale and each month following.
They are inventory buffer stocks that a firm holds to hedge uncertainties in delivery times, usage,
or sales.
94. What is an ABC System of Inventory Control?
It is a system of inventory control that categorizes inventory items as very important items (A
items) which are managed very carefully, fairly unimportant items (C items) which are managed
very casually, and items that fall between these two extremes (B items).
They are systems that schedule materials to arrive exactly as they are needed in the production
process.
96. Discuss the impact of a firm’s credit policy and the role its industry can play. Do credit
policy decisions involve receivables management? Explain.
Credit-policy affects a firm’s revenues and costs. For example, consider a policy of granting
credit more easily. A more liberal credit policy should increase the cost of goods sold, gross
profit, bad debt expenses, the cost of carrying additional receivables, and administrative costs.
However, the more liberal policy might or might not increase net profit. A policy’s profitability
depends on the incremental benefits and incremental costs. These are the additional gross profits
generated by the liberal policy minus the increase in costs, such as bad debt costs, carrying costs
on increased receivables, and administrative costs.
Depending on the industry, credit policy can vary from being crucial to being irrelevant. A retail
store may need a competitive policy to survive, whereas an electric utility must simply grant
credit according to government regulation. Credit-policy decisions involve all aspects of
receivables management. They include (1) the choice of credit terms, (2) setting evaluation
methods and credit standards, (3) monitoring receivables and taking actions for slow payment,
and (4) controlling and administering the firm’s credit functions.
97. Trade credit is effectively a loan from one firm to another. But it is a loan that is tied to a
purchase. The product and loan (credit) are bundled together. Give a reason for why this bundling
occurs? Name the seven specific market considerations that can account for this bundling.
Briefly, why is each an important consideration?
One reason is that bundling controls financial contracting costs that are created by market
imperfections. By using trade credit, both sides of the transaction must be able to lower the cost
or risk of doing business. Some specific market considerations are: financial intermediation,
collateral, information costs, product quality information, employee opportunism, steps in the
distribution process, and convenience, safety, and buyer psychology.
“Financial intermediation” is an important consideration because the interest rate of a trade credit
loan generally affects both partners. “Collateral” is key because suppliers know how to handle the
goods as collateral better than other lenders such as banks. “Information costs” are an essential
consideration because the credit-granting decision needs information to reach a proper decision.
“Product quality information” is crucial because the quality of the products influences credit
terms and timely payments. “Employee opportunism” considers the importance of controlling
employee theft and how credit policy can help reduce it. “Steps in the distribution process” is
valuable because it addresses the need to prevent payments at each step in the process. Finally,
“convenience, safety, and buyer psychology” are important. “Convenience and safety” are vital
consideration in cash management for both business and retail customers. “Psychology” is a
significant consideration because most retailers know that their customers would probably buy
less if they had to pay with cash or check instead of with credit.
98. What are credit standards? What variables do credit standards depend on? What three
factors reduce the NPV? Describe how each factor can cause a sale to be profitable or
unprofitable.
Credit standards are the criteria used to grant credit. They depend on the variables that determine
the NPV of the sale: investment in the sale, probability of payment, required return, and payment
period. A higher probability of default, delayed payments and the necessity of expensive
collection efforts all reduce the NPV.
A higher probability of payment is more likely to render a positive NPV. A lower probability most
often results in a negative NPV. If payments are delayed this reduces the NPV. The time value of
money on even a short-term payment can more than eliminate the profit. The present value of the
collection costs is an added cost of the sale. Higher collection costs reduce the NPV and can even
cause it to be negative. Collection costs have a fixed component, costs that are independent of the
amount of the credit sale. These fixed administrative or collection costs often make small credit
sales unprofitable.
99. Describe the primary internal and external sources of credit information.
There are three primary internal sources. The first internal source is a credit application, which
includes references. The second internal source is the applicant's previous payment history, if
credit has previously been extended. The third internal source involves information from sales
representatives and other employees.
There are four important external sources of credit information. First, there are financial
statements for recent years. These financial statements can be analyzed to get insights into the
customer's profitability, debt obligations, and liquidity. Second, there are reports from credit
rating agencies such as Dun & Bradstreet Business Credit Services (D&B). These agencies
supply credit appraisals of thousands of firms and estimates of their overall strength. D&B
appraises the credit of a firm relative to that of other firms of comparable financial strength and
assigns composite credit appraisal ratings between 1 (“high”) and 4 (“limited”). Third, there are
credit bureau reports. These reports provide factual information about whether a firm's financial
obligations are overdue. Credit bureau reports also give information about any legal judgments
against the firm. A final primary external source of credit information is industry association
credit files. Industry associations sometimes maintain credit files. Industry associations and your
direct competitors are frequently willing to share credit information about customers.
The Five C’s of Credit are five general factors that credit analysts often consider when making a
credit-granting decision. First is character. This refers to the commitment to meet credit
obligations. Character is best measured by a credit applicant’s prior payment history. Second is
capacity. Capacity refers to the ability to meet credit obligations with current income. Capacity is
evaluated by looking at the income or cash flows on the applicant’s income statement or
statement of cash flows. Third is capital. Capital refers to the ability to meet credit obligations
from existing assets if necessary. Capital is evaluated by looking at the applicant’s net worth.
Fourth is collateral. Collateral can be repossessed in the case of nonpayment. Collateral value
depends on the cost of repossessing and on the possible resale value. The fifth factor is
conditions. Conditions refer to the general or industry economic conditions. Conditions external
to the customer’s business affect the credit-granting decision. For example, improving or
deteriorating general economic conditions can change interest rates or the risk of granting credit.
Likewise, conditions in a particular industry can affect the profitability of granting credit to a firm
in that industry.