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Jim Khana, the credit manager of Velcro Saddles, is reappraising the company's credit policy. Velcro
sells on term of net 30. Cost of goods sold is 85% of sales and fixed costs are a further 5% of sales.
Velcro classifies customers on a scale of 1 to 4. During the past five years, the collection experience
was as follows:

Classification Defaults as Percent of Sales "Average Collection Period in Days for nondefaulting accounts"
1 0 45
2 2 42
3 10 40
4 20 80

The average interest rate was 15%?
What conclusions (if any) can you draw about Velcro's credit policy? What other factors should be taken into account before changing the policy?

#### Solution Preview

The best way to solve this problem is to calculate the NPV of \$100 sales to each of these customer types and see whether the NPV is positive or not. If the NPV is positive, we should sell to the customers in that category else we should avoid the customers in that category.
NPV = - COGS + 1*(1-Default percentage) ...

\$2.19

## Credit Policy

A firm currently makes only cash sales. It estimates that allowing trade credit on terms of net 30 would increase monthly sales from 200 to 220 units per month. The price per unit is \$101 and the cos (in present value terms) is \$80. The interest rate is 1 percent per month.

A. Should the firm change its credit policy?

B. Would your answer to a change if 5 percent of all customers will fail to pay their bills under the new credit policy?

C. What if 5 percent of only the new customers fail to pay their bills? The current customers take advantage of the 30 days of free credit b ut remain safe credit risks.