Chapter 20, Problem 1M

Credit Policy at Howlett Industries

Sterling Wyatt, the president of Howlett Industries, has been exploring ways of improving the company’s financial performance. Howlett manufactures and sells office equipment to retailers. The company’s growth has been relatively slow in recent years, but with an expansion in the economy, it appears that sales may increase more rapidly in the future. Sterling has asked Andrew Preston, the company’s treasurer, to examine Howlett’s credit policy to see if a change can help increase profitability.

The company currently has a policy of net 30. As with any credit sales, default rates are always of concern. Because of Howlett’s screening and collection process, the default rate on credit is currently only 1.6 percent. Andrew has examined the company’s credit policy in relation to other vendors, and he has found three available options.

The first option is to relax the company’s decision on when to grant credit. The second option is to increase the credit period to net 45, and the third option is a combination of the relaxed credit policy and the extension of the credit period to net 45. On the positive side, each of the three policies under consideration would increase sales. The three policies have the drawbacks that default rates would increase, the administrative costs of managing the firm’s receivables would increase, and the receivables period would increase. The effect of the credit policy change would impact all four of these variables to different degrees. Andrew has prepared the following table outlining the effect on each of these variables:

Howlett’s variable costs of production are 45 percent of sales, and the relevant interest rate is a 6 percent effective annual rate.

1. Which credit policy should the company use?

Summary Introduction

To evaluate: The credit policy of the firm.

Introduction:

Credit policy refers to a set of procedures that include the terms and conditions for providing goods on credit and principles for making collections.

Answer to Problem 1M

Company H should select Option 1, because it has the highest net present value (NPV) of $34,226,117.98 compared to other two options.

Explanation of Solution

The formula to calculate the average daily sales under current policy:

$\begin{array}{c}\text{Average daily sales under current policy = }\left(\frac{\text{Annual sales}}{\text{Days in a year}}\right)\\ =\frac{\$144,000,000}{365}\\ =\$394,520.55\end{array}$

Hence, the average sales under current policy is $394,520.55.

The formula to calculate average daily variable costs under current policy:

$\begin{array}{c}\begin{array}{l}\text{Average daily variable }\\ \text{costs under current policy}\end{array}\}\text{ =}\left[\frac{45\%ofsales}{\text{Days in a year}}\right]\\ =\left[\frac{.45\left(\$144,000,000\right)}{365}\right]\\ =\$177,534.25\end{array}$

Hence, the variable costs under current policy is $177,534.25.

The formula to calculate the average daily default under current policy:

$\begin{array}{c}\begin{array}{l}\text{Average daily default}\\ \text{under current policy }\end{array}\}\text{= }\left(\frac{\text{Default rate}\times \text{Annual sales }}{\text{ Days in a year}}\right)\\ =\frac{.016\times \$144,000,000}{365}\\ =\$6,312.33\end{array}$

Hence, the average daily default under current policy is $6312.33.

The formula to calculate average daily administrative cost under current policy:

$\begin{array}{c}\begin{array}{l}\text{Average daily administrative }\\ \text{costs}\text{under}\text{current policy }\end{array}\}\text{= }\left[\frac{\text{Administrative costs}\times \text{Annual sales}}{\text{Days in a year}}\right]\\ =\left[\frac{.022\times \$144,000,000}{365}\right]\\ =\$8,679.45\end{array}$

Hence, the average administrative costs under current policy is $8,679.45.

The formula to calculate the interest rate for the collection period:

$\begin{array}{c}\text{Interest rate =}{\left(\text{1+}\frac{\text{Annual interest rate}}{365}\right)}^{\text{Receivable period}}-1\\ {\left(1+\frac{\text{0}\text{.06 }}{\text{365}}\right)}^{\text{37}}\text{– 1}\\ =0.0061\text{or }\text{.61\%}\end{array}$

Hence, the interest rate is 0.61%.

The formula to calculate the net present value (NPV) under current policy:

$\begin{array}{c}\text{NPV =}\left[\begin{array}{l}-\text{Average daily variable cost +}\\ \frac{\left(\begin{array}{l}\text{Average daily sales}-\\ \text{Average daily variable cost}-\\ \text{Average daily default}-\\ \text{Average daily administrative costs}\end{array}\right)}{\text{Interest rate}}\end{array}\right]\\ =\left[-\$177,534.25+\frac{\left(\begin{array}{l}\$394,520.55-\$177,534.25\\ -\$6,312.33-\$8,679.45\end{array}\right)}{0.0061}\right]\\ \text{NPV = \$32,936,321}\text{.48}\end{array}$

Hence, the NPV under current policy is $32,936,321.48.

Option 1:

The formula to calculate the average daily sales under option 1:

$\begin{array}{c}\text{Average daily sales under option 1 = }\left(\frac{\text{Annual sales}}{\text{Number of days in a year}}\right)\\ =\frac{\$168,000,000}{365}\\ =\$460,273.97\end{array}$

Hence, the average daily sales under option 1 is $460,273.97.

The formula to calculate average daily variable costs under option 1:

$\begin{array}{c}\begin{array}{l}\text{Average daily variable }\\ \text{ costs under option 1}\end{array}\}\text{ =}\left[\frac{45\%ofsales}{\text{Number od days in a year}}\right]\\ =\left[\frac{.45\left(\$168,000,000\right)}{365}\right]\\ =\$207,123.29\end{array}$

Hence, the average daily variable costs under option 1 is $207,123.29.

The formula to calculate average daily default under option 1:

$\begin{array}{c}\begin{array}{l}\text{Average daily default}\\ \text{under option 1 }\end{array}\}\text{= }\left(\frac{\text{Default rate}\times \text{Annual sales }}{\text{Number of days in a year}}\right)\\ =\frac{.025\times \$168,000,000}{365}\\ =\$11,506.85\end{array}$

Hence, average daily default under option 1 is $11,506.85.

The formula to calculate average daily administrative cost under option 1:

$\begin{array}{c}\begin{array}{l}\text{Average daily administrative }\\ \text{costs}\text{under}\text{option 1 }\end{array}\}\text{= }\left[\frac{\text{Administrative costs}\times \text{Annual sales}}{\text{Number of days in a year}}\right]\\ =\left[\frac{.032\times \$168,000,000}{365}\right]\\ =\$14,728.77\end{array}$

Hence, the average daily administrative costs under option 1 is $14,728.77.

The formula to calculate interest rate for the for collection period:

$\begin{array}{c}\text{Interest rate =}{\left(\text{1+}\frac{\text{Annual interest rate}}{365}\right)}^{\text{Receivable period}}-1\\ {\left(1+\frac{\text{0}\text{.06 }}{\text{365}}\right)}^{40}\text{– 1}\\ =0.00659\text{or }\text{.659}\%\end{array}$

Hence, the interest rate is 0.659%.

The formula to calculate the net present value (NPV) under option 1:

$\begin{array}{c}\text{NPV =}\left[\begin{array}{l}-\text{Average daily variable cost +}\\ \frac{\left(\begin{array}{l}\text{Average daily sales}-\\ \text{Average daily variable cost}-\\ \text{Average daily default}-\\ \text{Average daily administrative costs}\end{array}\right)}{\text{Interest rate}}\end{array}\right]\\ =\left[-\$207,123.29+\frac{\left(\begin{array}{l}\$460,273.97-\$207,123.29\\ -\$11,506.85-\$14,728.77\end{array}\right)}{0.00659}\right]\\ \text{NPV = \$34,226,117}\text{.98}\end{array}$

Hence, the NPV under option 1 is $34,226,117.98.

Option 2:

The formula to calculate the average daily sales under option 2:

$\begin{array}{c}\text{Average daily sales under option 2 = }\left(\frac{\text{Annual sales}}{\text{Number of days in a year}}\right)\\ =\frac{\$165,000,000}{365}\\ =\$452,054.79\end{array}$

Hence, the average daily sales under option 2 is $452,054.79.

The formula to calculate average daily variable costs under option 2:

$\begin{array}{c}\begin{array}{l}\text{Average daily variable }\\ \text{ costs under option 2}\end{array}\}\text{ =}\left[\frac{45\%ofsales}{\text{Number od days in a year}}\right]\\ =\left[\frac{.45\left(\$165,000,000\right)}{365}\right]\\ =\$203,424.66\end{array}$

Hence, the average daily variable costs under option 2 is $203,424.66.

The formula to calculate average daily default under option 2:

$\begin{array}{c}\begin{array}{l}\text{Average daily default}\\ \text{under option 2 }\end{array}\}\text{= }\left(\frac{\text{Default rate}\times \text{Annual sales }}{\text{Number of days in a year}}\right)\\ =\frac{.018\times \$165,000,000}{365}\\ =\$8,136.99\end{array}$

Hence, the average daily default under option 2 is $8,136.99.

The formula to calculate average daily administrative cost under option 2:

$\begin{array}{c}\begin{array}{l}\text{Average daily administrative }\\ \text{costs}\text{under}\text{option 2 }\end{array}\}\text{= }\left[\frac{\text{Administrative costs}\times \text{Annual sales}}{\text{Days in a year}}\right]\\ =\left[\frac{.024\times \$165,000,000}{365}\right]\\ =\$10,849.32\end{array}$

Hence, the average daily administrative costs under option 2 is $10,849.32.

The formula to calculate interest rate for the for collection period:

$\begin{array}{c}\text{Interest rate =}{\left(\text{1+}\frac{\text{Annual interest rate}}{365}\right)}^{\text{Receivable period}}-1\\ {\left(1+\frac{\text{0}\text{.06 }}{\text{365}}\right)}^{50}\text{– 1}\\ =0.00825\text{or }\text{.825}\%\end{array}$

Hence, the interest rate is 0.852%.

The formula to calculate NPV under option 2:

$\begin{array}{c}\text{NPV =}\left[\begin{array}{l}-\text{Average daily variable cost +}\\ \frac{\left(\begin{array}{l}\text{Average daily sales}-\\ \text{Average daily variable cost}-\\ \text{Average daily default}-\\ \text{Average daily administrative costs}\end{array}\right)}{\text{Interest rate}}\end{array}\right]\\ =\left[-\$203,424.66+\frac{\left(\begin{array}{l}\$452,054.79-\$203,424.66\\ -\$8,136.99-\$10,849.32\end{array}\right)}{0.00825}\right]\\ \text{NPV = \$27,632,189}\text{.89}\end{array}$

Hence, the NPV under option 2 is $27,632,189.89.

Option 3:

The formula to calculate the average daily sales under current policy:

$\begin{array}{c}\text{Average daily sales under option 3 = }\left(\frac{\text{Annual sales}}{\text{Number of days in a year}}\right)\\ =\frac{\$180,000,000}{365}\\ =\$493,150.68\end{array}$

Hence, the average daily sales under option 3 is $493,150.68.

The formula to calculate average daily variable costs under option 3:

$\begin{array}{c}\begin{array}{l}\text{Average daily variable }\\ \text{ costs under option 3}\end{array}\}\text{ =}\left[\frac{45\%ofsales}{\text{Number od days in a year}}\right]\\ =\left[\frac{.45\left(\$180,000,000\right)}{365}\right]\\ =\$221,917.81\end{array}$

Hence, the average daily variable costs under option 3 is $221,917.81.

The formula to calculate average daily default under option 3:

$\begin{array}{c}\begin{array}{l}\text{Average daily default}\\ \text{under option 3 }\end{array}\}\text{= }\left(\frac{\text{Default rate}\times \text{Annual sales }}{\text{Number of days in a year}}\right)\\ =\frac{.022\times \$180,000,000}{365}\\ =\$10,849.32\end{array}$

Hence, the average daily default under option 3 is $10,849.32.

The formula to calculate average daily administrative cost under option 3:

$\begin{array}{c}\begin{array}{l}\text{Average daily administrative }\\ \text{costs}\text{under}\text{option 3 }\end{array}\}\text{= }\left[\frac{\text{Administrative costs}\times \text{Annual sales}}{\text{Days in a year}}\right]\\ =\left[\frac{.03\times \$180,000,000}{365}\right]\\ =\$14,794.52\end{array}$

Hence, the average daily administrative costs under option 3 is $14,794.52.

The formula to calculate interest rate for collection period:

$\begin{array}{c}\text{Interest rate =}{\left(\text{1+}\frac{\text{Annual interest rate}}{365}\right)}^{\text{Receivable period}}-1\\ {\left(1+\frac{\text{0}\text{.06 }}{\text{365}}\right)}^{48}\text{– 1}\\ =0.00792\text{or }\text{.792\%}\end{array}$

Hence, the interest rate is 0.792%.

The formula to calculate NPV under option 3:

$\begin{array}{c}\text{NPV =}\left[\begin{array}{l}-\text{Average daily variable cost +}\\ \frac{\left(\begin{array}{l}\text{Average daily sales}-\\ \text{Average daily variable cost}-\\ \text{Average daily default}-\\ \text{Average daily administrative costs}\end{array}\right)}{\text{Interest rate}}\end{array}\right]\\ =\left[-\$221,917.81+\frac{\left(\begin{array}{l}\$493,150.68-\$221,917.81\\ -\$10,849.32-\$14,794.52\end{array}\right)}{0.00792}\right]\\ \text{NPV = \$30,786,798}\text{.099}\end{array}$

Hence, the NPV under option 3 is $30,786,798.099.