Dexter Metal House (DMH) is considering changing its credit terms from '2/15 net 30' to '3/10 net 30' in order to speed collections. At present, 40 percent of DMH's non default customers take the 2…

Model Answer: Financial Management (FIN207) – Credit Policy Analysis

1. Understanding the Problem

Dexter Metal House (DMH) is evaluating a change in its credit terms from '2/15 net 30' to '3/10 net 30' to improve cash flow. The key variables affecting working capital and profitability are:

• Discount-taking behavior (percentage of customers availing discounts).
• Payment timing (early, on-time, or late payments).
• Bad debt losses (assumed constant at 2%).

We must calculate the average collection period (ACP) and cost of granting credit under both scenarios to determine the financial impact.

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2. Assumptions and Given Data

Note: All percentages are of non-default customers (i.e., excluding bad debts).

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3. Calculating Average Collection Period (ACP)

The ACP is computed as the weighted average days taken to collect receivables, excluding bad debts.

Current Terms (2/15 net 30)

1. Discount-taking customers (40%):

   • Pay by Day 15 (since they take the 2% discount).
   • Weighted days = $15\times 0.40=6$ days.

2. Non-discount customers (60%):

   • On-time (50% of 60%): Pay by Day 30.
     • Weighted days = $30\times 0.30=9$ days.
   • Late (50% of 60%): Pay by Day 40.
     • Weighted days = $40\times 0.30=12$ days.

3. Total ACP (Current): $$AC{P}_{\text{current}}=6+9+12=\boxed{27\text{ days}}$$

New Terms (3/10 net 30)

1. Discount-taking customers (50%):

   • Pay by Day 10 (since they take the 3% discount).
   • Weighted days = $10\times 0.50=5$ days.

2. Non-discount customers (50%):

   • On-time (50% of 50%): Pay by Day 30.
     • Weighted days = $30\times 0.25=7.5$ days.
   • Late (50% of 50%): Pay by Day 40.
     • Weighted days = $40\times 0.25=10$ days.

3. Total ACP (New): $$AC{P}_{\text{new}}=5+7.5+10=\boxed{22.5\text{ days}}$$

Observation: The ACP decreases from 27 days to 22.5 days, improving cash flow efficiency.

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4. Calculating Cost of Granting Credit

The cost of granting credit includes:

1. Discount lost (opportunity cost of offering discounts).
2. Bad debt losses (2% of sales, unchanged).
3. Carrying cost of receivables (implicit cost of tying up funds).

We assume annual sales (S) = Rs. 1,00,000 (for simplicity; actual value cancels out in percentage terms).

Current Terms (2/15 net 30)

1. Discount lost:

   • 40% of customers take a 2% discount.
   • Total discount given = $0.40\times 0.02\times S=0.008S$.
   • Opportunity cost = $0.008S\times (1-\text{tax rate})$. (Assuming no tax for simplicity, cost = 0.8% of S.)

2. Bad debts:

   • 2% of sales = $0.02S$.

3. Carrying cost of receivables:

   • ACP = 27 days → Average receivables = $\frac{S}{365}\times 27=0.074S$.
   • Cost of capital (assume 12%) = $0.074S\times 0.12=0.00888S$ (0.888% of S).

4. Total cost of credit (current): $$0.8\%+2\%+0.888\%=\boxed{3.688\%\text{ of sales}}$$

New Terms (3/10 net 30)

1. Discount lost:

   • 50% of customers take a 3% discount.
   • Total discount given = $0.50\times 0.03\times S=0.015S$.
   • Opportunity cost = 1.5% of S.

2. Bad debts:

   • Unchanged at 2% of S.

3. Carrying cost of receivables:

   • ACP = 22.5 days → Average receivables = $\frac{S}{365}\times 22.5=0.0616S$.
   • Cost of capital = $0.0616S\times 0.12=0.007392S$ (0.7392% of S).

4. Total cost of credit (new): $$1.5\%+2\%+0.7392\%=\boxed{4.2392\%\text{ of sales}}$$

Observation: The total cost of credit increases from 3.688% to 4.2392% due to:

• Higher discount rate (3% vs. 2%).
• Slightly lower carrying cost (due to reduced ACP).

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5. Financial Implications

Key Takeaways:

1. Liquidity Improvement: The ACP drops by 4.5 days, reducing the need for external financing.
2. Higher Discount Cost: The 3% discount attracts more customers (50% vs. 40%), increasing cash outflow.
3. Net Effect: While the carrying cost decreases, the increase in discount cost outweighs it, making the new policy slightly more expensive (by ~0.55% of sales).
4. Strategic Consideration:
   • If DMH’s goal is faster collections, the policy achieves this.
   • If profitability is the priority, the current terms may be better unless the increased sales from more discount-takers offset the higher cost.

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6. Recommendation (Optional Extension)

If DMH expects higher sales volume due to the new terms (e.g., attracting more customers), a cost-benefit analysis should include:

• Incremental sales revenue from additional discount-takers.
• Additional bad debts (if any, though the problem states none).
• Tax implications of discounts (if applicable).

Conclusion: The new credit terms reduce collection time but increase the cost of granting credit. DMH should evaluate whether the liquidity benefits justify the higher discount cost or explore intermediate policies (e.g., 2.5/12 net 30).

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Final Numerical Results:

• Current ACP: 27 days
• New ACP: 22.5 days
• Current Cost of Credit: 3.688% of sales
• New Cost of Credit: 4.2392% of sales