Question

Limo Ltd is a small family owned company that has been suffering from the credit crunch and has very limited borrowing power. The company gets it finance mainly from bank overdraft which has been tightened up and the interest rate has been increasing.

One of the main problems is that the company suffers from the late payment of their debtors and even default. Limo offers credit to all of its customers and most of them pay after the due dates. The board of directors decided to look into their cash flow situation and new proposal were put forward for consideration.

1. Delaying payment to creditors: at the moment Limo pays its creditors on 30 days from invoice. Often the invoice is received before the good arrived. The credit manager proposed delaying payment to creditors till customers pay.

2. Offering discount for prompt payment to debtors. At the moment the debtor payment system is as follow:

· 0nly 20% of customers pay within one month

· 15% pay after two month

· As many as 50% pay after three month and

· 13% pay take four months to pay

The board of director consider this patter unacceptable and wants to bring payment forward. A marketing research conducted last month showed that if a two-part-term is introduced for payment within 1 month at 2.5% discount then the patter will improve as follows:

· As many as 70% will take the discount and pay within one month

· Only 5% will pay within two month

· 10% will pay within three month and

· And the payment after four month increases by 1% to 14%

3. The company may try to negotiate a five year loan backed up by one of the marketable assets.

The company’s cost of capital is 15% and the annual turnover is £12m.

You are required to:

a) Discuss the different options and make some recommendations.

b) Evaluate the discount for prompt payment to see whether or not such a scheme is worth introducing (it is necessary to compute the expected costs and benefits of the discounts).

c) Discuss other additional benefits of introducing a prompt payment schemes

Answer 1

a) In the first proposal of the credit manager of Limo Ltd. for delaying payment until the customer pays it to the company, the company receives only a 20% of the debtors in one month which is the Payment cycle of present scenario but if payment gets delayed as per the receiving pattern from debtors then company can save its opportunity cost of paying instant to the creditors. In this option, the company can save opportunity cost on 80% of the creditor's amount for respective time until it pays to them.

In the second proposal, we can compare the total inflows that are the present value of future cash flows at the discounting rate of 15% p.a. with the existing system of Limo Ltd. In the existing scenario, the company is losing its 2% of revenue as bad debts but after applying a prompt payment scheme by giving a discount to its customers, the company is in a net advantageous position from this scheme.

In the third option of negotiating a loan for 5 years, company has to incur a borrowing cost at marketable assets rate i.e. 15% at present which is not an advisable option because company has to bear interest for 5 years just to pay the creditors.

As per our recommendation, the company should go with a discount for prompt payment scheme.

b) The answer is as follows.

2		Option 1						Option 2
	Month	Cash inflows(M$)	PV Factor	Amount			Month	Cash inflows(M$)	PV Factor	Amount
	1	2.40	0.99	2.37			1	8.19	0.99	8.09
	2	1.80	0.98	1.76			2	0.60	0.98	0.59
	3	6.00	0.96	5.78			3	1.20	0.96	1.16
	4	1.56	0.95	1.48			4	1.68	0.95	1.60
				11.39						11.43
					Net Benefit		0.04

c) other additional benefits are :

i) The company can save its bad debts as in the present 2% debtors are not recoverable, but in prompt payment, the scheme company will get its full recovery of debts.

ii) The company can save its interest cost on Borrowing for 5 year backed with an interest rate at marketable asset.