Question

 

ADS Fashions is a specialty clothing store. Its credit managers are trying to decide which credit policy to choose from the following 3 proposals.

The company has an annual opportunity cost and cost of capital of 10%. Assume Variable Costs occur at time 0, and that Sales less Bad Debt Costs less Credit Administration & Collection expenses all occur on the latest payment date that customers pay for credit sales. The Variable Cost Ratio (VCR) is 40% for each of the proposals.

Find the PV of revenues less PV Costs for each of the following policies to see which one gives the highest present value (PV), and explain which Policy would be best, i.e. give the highest Daily PV of Revenues – PV Costs.

(Policy 1) Under its existing credit policy, the company has Annual Credit Sales of $10,000,000. Bad debts as a percentage of total sales of 2%. Credit administration and Collection expenses as a percentage of total sales of 3%. Customers take on average 30 days to pay.

(Policy 2) Under a proposed new, more relaxed credit policy 2, the firm’s Annual Credit Sales are expected to rise to $12,000,000. Bad debts as a percentage of total sales are expected to rise to 2.5% of sales. Credit administration and Collection expenses as a percentage of total sales are expected to go up to 3.5%, and Customers are expected to take 40 days to pay.

(Policy 3) Under a proposed new credit policy 3, the firm would offer a Discount of 2%, with terms of 2/10, net 40, and 50% of customers would be expected to take the 2% discount and pay on day 10, and 50% of customers would be expected to not take the discount and pay on day 40. Credit Sales annually are expected to go up to $12,500,000. Bad debts are be expected to fall to 2%, and Credit administration and Collection expenses as a percentage of sales are expected to fall to 1.5%.

Answer 1

Statement showing evaluation of Policies -

Particulars	Policy 1	Policy 2	Policy 3
Credit Sales	$ 10,000,000	$12,000,000	$12,500,000
Less : Bad Debts (2%/2.50%/2%)	$200000	$300000	$250000
Less : Collection Expenses(3%/3.50%/1.50%)	$300000	$420000	$187500
Cash Inflows after credit period	$9500000	$11280000	$12062500
Present Value of Cash Inflows i.e. cash inflows as period 0 - (B)	$9500000/(1.008219) = $ 9,422,556	$11280000/(1.010958) = $ 11,157,734	$ 11855989 (Refer note below)
Present Value of Cash Outflows = Variable cost(40%) - (A)	$4000000	$ 4800000	$5000000
Net Benefit (B - A)	$ 5422556	$6357734	$6855989
Final Answer - Policy 3 is more beneficial.

Note 1-

Calculation of discounting rates -

0.10* 10 days /365 = 0.002739 or 0.27 %

0.10 * 30 days/365 = 0.008219 or 0.82 %

0.10 " 40 days/365 = 0.010958 or 1.09 %

50% of customers would pay on day 40, PV of which is as follows -

$6031250/(1.010958) =(A) $ 5,965,876

Rest 50% of customers would avail 2% cash discount and pay on day 10, PV of which is as follows -

($6031250 - cash discount*)/(1.002739)

or ($5906250)/(1.002739)= (B) $ 5890113

Total (A+B) = $ 11855989

* Cash discount = 50% of $ 12500000× 2% = $ 125000