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Trade Credit: NPV, Factors Affecting Collection Period

You work for a company that extends trade credit to customers. Currently your variable cost ratio is 65% and the annual rate of interest set by the company is 4% and the terms are a 30-day net. It costs you $0.07 on the dollar for administrative costs.
Your monthly credit extension is $400,000 and you know (based on previous calculations) that 30% of your customers pay within 30 days, 30% pay within the 60-day net period, 25% pay within a 90-day period and the last 15% pay in a 120-day period. Calculate NVP of the extended trade credit.
Next, calculate the average collection period. If the current industry standard collection period is 40 days, determine if an early payment credit is worth implementing. How great of a discount should you provide?
Finally, what other factors would you consider when implementing an early payment discount? Why?

Solution Preview

NPV of Extended Trade Credit:
Net present value (NPV) of a credit extension or granting plan depends on some important factors that include revenue effects, cost effects, cost of debt or capital, probability of non-payment, and cash discounts (Ross, Westerfield & Jordan, 2008).

The calculation of NPV of trade credit extension plan is as follow:
Selling price = $1 (it is assumed due to absence of information about selling price)
Current variable cost ratio = 65%
Current variable cost = $0.65 (65% of selling price)
Administrative cost = $0.07
Total cost per unit = Variable cost + Administrative cost
= $0.65 + $0.07
= $0.72
Annual interest rate = 4%
Current credit term = 30-day net
Monthly credit extension = $400000
The credit terms of the credit extension plan are summarized in the table below:
S.No Credit Period Percentage of Credit Amount
1 30 days 30%
2 60 days 30%
3 90 days 25%
4 120 days 15%
Total 100%

The calculation of collection amount according to new credit policy is summarized in the below table:
S. No Credit Period Percentage Total Credit Sales Collected Amount
1 30 days 30% $400000 30% × 400000 = $120000
2 60 days 30% $400000 30% × 400000 = $120000
3 90 days 25% $400000 25% × 400000 = $100000
4 120 days 15% $400000 15% × 400000 = $60000
Total 100% $400000

The calculation of present value of collection with different credit term is as below -
Present value of collection (if pay within 30 days) = 120000 ÷ (1+ 4% ÷ 12)
= 120000 ÷ (1 + 0.0033)
= $119605.30
Present value of collection (if pay within 60 days) = 120000 ÷ (1+ 4% ÷ 6)
...

Solution Summary

The solution discusses the trade credit, in particular the net present value, and factors affecting the collection period.

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