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    Corporate credit - costs and benefits of credit discount policy

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    Managing credit - figures and bullet point for report

    Company has revenue of £500 million and sells all of its goods on credit to a variety of different wholesale customers.

    At the moment the company offers a standard credit period of 30 days.

    However, 70% of its customers (by revenue) take an average of 70 days to pay, while the other 30% of customers (by revenue) pay within 30 days.

    The company is considering offering a 2% discount for payment within 30 days and estimates that 80% of customers (by revenue) will take up this offer (including those that already pay within 30 days).

    The Managing Director has asked the credit controller if the cost of this new policy would be worth offering.

    The company has a £80 million overdraft facility that it regularly uses to the full limit due to the lateness of payment and the cost of this overdraft facility is 15% per annum.

    The credit controller also estimates that bad debt level of 2% of revenue would be halved to 1% of revenue as a result of this new policy.

    1 Calculate the approximate equivalent annual percentage cost of a discount of 2%, which reduces the time taken by credit customers to pay from 70 days to 30 days.

    2 Calculate the value of trade receivables under the existing scheme and the proposed scheme at the year-end.

    3 Evaluate the benefits and costs of the scheme and explain with reasons whether the company should go ahead and offer the discount. You should also consider other factors in this decision. (Hint: You need to work out the cost of the discount compared to the interest on the overdraft saved and bad debt reduction.)

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    Solution Preview

    The quantification of the costs and benefits of the 2% discount scheme is highly dependent on the amount and timing of individual orders. For simplification of analysis, let us consider a scenario where the Eur. 500 mn. of revenue comprises of 10 orders, each worth Eur. 50 mn., spread out over the year. The details of repayment over different cases is as mentioned below.
    Scenario 1: 70% customers pay after 70 days of order; remaining 30% customers pay within 30 days.
    We have considered Order 1, 4 and 6 (3 orders out of 10, i.e. 30%; highlighted in red below) as payable within 30 days and remaining 7 orders as payable after 70 days
    The actual payment date and receivable amount at the end of each month ...

    Solution Summary

    The writeup illustrates the costs and benefits of providing discounts for early payment of receivables by clients with quantification of revenue loss due to discount, impact on bad debt and savings on interest cost of overdraft facility for receivables.