a. Discuss, in general, what it means for the brothers to set a credit and collections policy.

Question:

a. Discuss, in general, what it means for the brothers to set a credit and collections policy.
b. Assume that, on average, the brothers expect annual sales of 18,000 items at an average price of $100 per item. (Use a 365-day year.)
1. What is the firm's expected days sales outstanding (DSO)?
2. What is its expected average daily sales (ADS)?
3. What is its expected average level?
4. Assume that the firm's profit margin is 25%. How much of the receivables balance must be financed? What would the firm's figures for notes payable and retained earnings be at the end of 1 year if notes payable are used to finance the investment in receivables? Assume that the cost of carrying receivables had been deducted when the 25% profit margin was calculated.
5. If bank loans have a cost of 12%, what is the annual dollar cost of carrying the receivables?
c. What are some factors that influence (1) a firm's receivables level and (2) the dollar cost of carrying receivables?
d. Assuming that the monthly sales forecasts given previously are accurate, and that customers pay exactly as was predicted, what would the receivables level be at the end of each month? To reduce calculations, assume that 30% of the firm's customers pay in the month of sale, 50% pay in the month following the sale, and the remaining 20% pay in the second month following the sale. Note that this is a different assumption than was made earlier. Also assume there are 91 days in each quarter. Use the following format to answer parts d and e:

e. What is the firm's forecasted average daily sales for the first 3 months? For the entire half-year? The days sales outstanding is commonly used to measure receivables performance. What DSO is expected at the end of March? At the end of June? What does the DSO indicate about customers' payments?
f. Construct aging schedules for the end of March and the end of June (use the format given below).

g. Assume now that it is several years later. The brothers are concerned about the firm's current credit terms, which are now net 30, which means that contractors buying building products from the firm are not offered a discount, and are supposed to pay the full amount in 30 days. Gross sales are now running $1,000,000 a year, and 80% (by dollar volume) of the firm's paying customers generally pay the full amount on Day 30, while the other 20% pay, on average, on Day 40. Of the firm's gross sales, 2% end up as bad debt losses. The brothers are now considering a change in the firm's credit policy. The change would entail (1) changing the credit terms to 2/10, net 20, (2) employing stricter credit standards before granting credit, and (3) enforcing collections with greater vigour than in the past. Thus, cash customers and those paying within 10 days would receive a 2% discount, but all others would have to pay the full amount after only 20 days. The brothers believe that the discount would both attract additional customers and encourage some existing customers to purchase more from the firm-after all, the discount amounts to a price reduction. Of course, these customers would take the discount and, hence, would pay in only 10 days. The net expected result is for sales to increase to $1,100,000; for 60% of the paying customers to take the discount and pay on the 10th day; for 30% to pay the full amount on Day 20; for 10% to pay late on Day 30; and for bad debt losses to fall from 2% to 1% of gross sales. The firm's operating cost ratio will remain unchanged at 75%, and its cost of carrying receivables will remain unchanged at 12%. To begin the analysis, describe the four variables that make up a firm's credit policy, and explain how each of them affects sales and collections. Then use the information given in part g to answer parts h through m.
h. Under the current credit policy, what is the firm's days sales outstanding (DSO)? What would the expected DSO be if the credit policy change were made?
i. What is the dollar amount of the firm's current bad debt losses? What losses would be expected under the new policy?
j. What would be the firm's expected dollar cost of granting discounts under the new policy?
k. What is the firm's current dollar cost of carrying receivables? What would it be after the proposed change?
l. What is the incremental after-tax profit associated with the change in credit terms? Should the company make the change? (Assume a tax rate of 40%.)

m. Suppose the firm makes the change, but its competitors react by making similar changes to their own credit terms, with the net result being that gross sales remain at the current $1,000,000 level. What would the impact be on the firm's after-tax profitability?
Rich Jackson, a recent finance graduate, is planning to go into the wholesale building supply business with his brother, Jim, who majored in building construction. The firm would sell primarily to general contractors, and it would start operating next January. Due to the nature of the products, sales would be relatively constant with some fluctuations month to month. Sales estimates for the first 6 months are as follows (in thousands of dollars):

The terms of sale are net 30, but because of special incentives, the brothers expect 30% of the customers (by dollar value) to pay on the 10th day following the sale, 50% to pay on the 40th day, and the remaining 20% to pay on the 70th day. No bad debt losses are expected, because Jim, the building construction expert, knows which contractors are having financial problems.

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