1. Why is some trade credit called free while other credit is called costly? If a firm buys on terms on 2/10,net 30, pays at the end of the 30th day, and typically shows $300,000 of accounts payable on its balance sheet, would the entire $300,000 be free credit? Would it be costly credit, or would some be free and some costly?. Please explain answer and no calculations is needed.
2. Working Capital policy: The Rentz corporation is investigating the optimal level of current rent assets for the coming year. Management expects sales to increase to approximately $2million as a result of an asset expansion presently being undertaken .Fixed assets total $1million, and the firm plans to maintain a 60% debt ratio. Rentz's interest rate is currently 8% on both short-term and longer-term debt (which the firm uses in its permanent structure) Three alternatives regarding the projected current assets level are under consideration:(1) a tight policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 12% of total sales, and the federal -plus-state tax rate is 40%.
a). What is the expected return on equity under each current asset level?
b): In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption?
c): How would the firm's risk be affected by the different policies?
1. Trade credit is sometimes called free as there is no interest payable on amount taken for trade credit. So there is no explicit cost. However, in most cases there are cash discounts which the firm can avail which results in implicit cost of trade credit. Other forms of credit require payment of interest and hence called costly.
If the amount is paid on the 10th day, the company will get a 2% discount of the payments. However, if the amount is paid on the 30th day, there is no discount available. Thus, the initial 10 days of the credit is free credit (no implicit or explicit cost) and the remaining 20 ...
This solution defines and explains the characteristics of trade credit and gives a detailed spreadsheet on the expected return on equity under the current asset level. It also explains how the firm's risk was affected by different policies.
Working Capital Management Assumptions
Upscale Toddlers, Inc. manufactures children's clothing, including such accessories as socks and belts. The company has been in business since 1955, mainly supplying private label merchandise to large department stores. In 1990, however, the company started producing its own line of children's clothing under the brandname "Yuppiewear." An increasing number of 2 income families has been accompanied by an increasing demand for high-status children's clothing, and Toddlers was the first in its field to recognize this trend.
When Toddlers' sales were primarily for private labels, the firm's financial managerdid not have to worry much about its overall credit policy. Most of its sales were negotiated directly with department store buyers, and resulting contracts contained specific credit terms. The new line, however, represents a significant change. It is sold through numerous wholesalers under standard credit terms, so credit policy per se has become important. Elizabeth Hardin, the assistant treasurer, has been assigned the task of reviewing the company's current credit policy and recommending any desirable changes.
Toddlers' current credit terms are 2/10, net 30. Thus, wholsalers buying from Toddlers receive a 2 percent discount off the gross purchase price if they pay within ten days, while customers who do not take the discount must pay the full amount within 30 days. The company does check the financial strength of financial of potential customers, but its standards for granting credit are not high. Similarly, it does have procedures for collecting past-due accounts, but its collections policy could best be described as passive. Gross sales to wholesalers average about $15 million a year, and 50% of the paying wholesalers take the discount and pay, on average, on Day 10. Another 30% of the payers generally pay the full amount on day 30, while 20% tend to stretch Toddlers' terms and do not actually pay, on average, until Day 40. Two percent of Toddlers' gross sales to wholesalers end up as bad debt losses.
Nathan Langly, the treasurer and Hardin's boss, is convinced that the firm should tighten up its credit policy are probably not good customers. Hardin must make an analysis and then recommend a course of action. For political reasons, she has decided to focus on a tighter policy, under which a 4% discount would be offered to customers who pay cash on delivery and 20 days of credit would be offered to customers who elect not to take the discount. Also, under the new policy stricter credit standards would be applied, and a tougher collection policy would be enforced.This policy has been dubbed 4/COD, net 20.
Langly likes this policy. He believes that increasing the discount would both bring in new customers and also encourage more of Toddlers' existing customers to take the discount. As a result, he believes that sales to wholesalers would increase from $15 million to 16.5 million annually, that 60% of the paying customers would take the discount, that 30% of the payers would pay on Day 20, that 10% would pay late on Day 30, and that bad debt losses would be reduced to 1% of gross sales. Langly's is not the only position, though. Arnold Quayle, the sales manager, has argued for an easier credit policy. Quayle thinks that the proposed change would result in a drastic loss of sales and profits.
Toddlers' variable cost to sales ratio is 80%; its pre-tax cost of carrying receivables is 12%; and the company can expand without any problems (or any cost increases) because it can subcontract production that it cannot handle in-house. Further, Langly is convinced that neither the variable cost ratio nor the cost of capital would change as a result of a credit policy change. Arnold Quayle, however, thinks that the variable cost ratio might increase significantly if sales rise so much that the company is forced to use outside suppliers. Also, after discussions with the cost accounting staff, Quayle thinks that the variable cost ratio might as high as 90% this coming year, even without an increase in sales, due to higher labor costs under a contract now being negotiated. Everyone agrees that there is little chance that costs will decline, regardless of the credit policy decision. Toddlers' federal-plus-state tax rate is 40%.
Now Hardin must conduct an analysis to estimate the effect of the proposed credit policy change on Toddlers' profitability. She and Langly are very much concerned about the analysis, both because of the importance to the company and also because of its "political implications". The sales and production people have been lobbying against any credit tightening because they do not want to take a chance on losing sales and having to cut production, and also because they question the assumptions Langly wants to use. Therefore, Hardin knows that her report will be critically reviewed and a thorough analysis is required. She is especially concerned about being prepared for follow-up questions that other people, such as those in sales and production, might ask when the report is being reviewed. The report should consider all relevant factors, including an analysis of both the current and proposed credit policies and a recommendation as to what Toddlers should do.
Hardin has requested that you assist with the report. She is not certain what risks are involved with a credit policy change or if such risks can even be assessed and incorporated in the analysis. Meanwhile, Langly has expressed concern that if the firm changes its credit policy, Toddlers' competitors may react by making similar changes in their terms. Thus, Toddlers would have a new credit policy without any change in sales.
As with every report presented to management, there probably will be a number of questions regarding the assumptions used in the analysis. Specifically, Hardin expects both the sales and production managers to questions the assumptions, so she would like to know which variables are most critical in the sense that profitability is very sensitive to them. No one has yet determined just how far off the assumptions could be before the change to a tighter credit policy would be incorrect. Also, if she could, Hardin would like to have a better basis for the assumptions used in her report - as it stands, all she has to rely on is Langly's judgement, which is contrary to that of two other senior executives. However, she is not sure whether any additional actions could be taken to improve the accuracy of the forecasts.
Langly gave you a portion of a letter he recently received from Ivana Tinkle, a member of Toddler's board of directors. Ivana who also sits on the Board of Face Cosmetics, Inc., has been involved in numerous credit policy decisions. The decisions made by Face were always successful from a profitability standpoint. Thus, Ivana suggests that Toddlers use the same algebraic approach used by Face, in addition to constructing projected profit statements. Pages 2 and 3 of Ivana's letter are set forth in Exhibit 1. Ivana is a very influential member of the board, so be prepared to address her suggestion.
Working with Langly, she prepared the following set of questions for use as a guide in drafting her report. Put yourself in her position and answer the following questions. As you answer each question, think about follow-up questions that other people, such as those in sales and production, might ask when the report is being reviewed.
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