Question: Ray now asks you to examine his company s credit policy

Ray now asks you to examine his company’s credit policy to determine whether changes are needed. One of his employees, who graduated recently with a finance major, has recommended that the credit terms be changed from 2/10, net 30, to 3/20, net 45, and that both the credit standards and the collection policy be relaxed. According to the employee, such a change would cause sales to increase from $3.6 million to $4.0 million. Currently, 62.5 percent of SSP’s customers pay on Day 10 of the billing cycle and take the discount, 32 percent pay on Day 30, and 5.5 percent pay (on average) on Day 60. If the firm adopts the new credit policy, Ray thinks that 72.5 percent of customers would take the discount, 10 percent would pay on Day 45, and 17.5 percent would pay late, on Day 90. Bad debt losses for both policies are expected to be trivial. SSP’s variable operating costs are currently 75 percent of sales, its cost of funds is 10 percent, and its marginal tax rate is 40 percent. None of these factors would change as a result of a credit policy change. All cash payments associated with the production and sale of products (including credit costs) are made on the day the products are sold.
To help him decide whether to adopt the new policy, Ray has asked you to answer the following questions.
a. What variables make up a firm’s credit policy? In what direction would each be changed if the credit policy were tightened? How would each variable tend to affect sales, the level of receivables, and bad debt losses?
b. How are the days sales outstanding and the average collection period related? What would the DSO be if SSP maintains its current credit policy? If it adopts the proposed policy?
c. What is the dollar amount of discounts granted under the current and the proposed credit policies?
d. Should SSP make the change?
e. Suppose the company makes the proposed change but its competitors react by changing their own credit terms, with the net result being that SSP’s gross sales remain at the $3.6 million level. How would this situation affect the company’s value?
f. (1) What does the term “monitoring accounts receivable” mean?
(2) Why would a firm want to monitor its receivables?
(3) How might the DSO and the aging schedule be used in this process?

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