ch21 cost of capital

7/28/2019 ch21 Cost of capital

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Cash Discounts: Lowers price.

Attracts new customers andreduces DSO.

Credit Period: How long to pay?

Shorter period reduces DSO andaverage A/R, but it may discouragesales.

Elements of Credit Policy

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Credit Standards: Tighter standards reduce bad debt losses,but may reduce sales. Fewer bad

debts reduces DSO.Collection Policy: Tougher policy

will reduce DSO, but may damagecustomer relationships.



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January $100 April $300

February 200 May 200

March 300 June 100

Terms of sale: Net 30.

Receivables Monitoring

Assume the following sales estimates:



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A/R $182,466 Notes payable $136,849

Retained earnings 45,617

$182,466

If notes payable are used to finance

the A/R investment, what does thefirm’s balance sheet look like?



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= 0.12($136,849)

= $16,422.

In addition, there is an opportunity costof not having the use of the profit com-ponent of the receivables.

If bank loans cost 12 percent,

what is the annual dollar cost of carrying the receivables?

Cost of carryingreceivables



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Receivables are a function of average daily sales and days salesoutstanding.

State of the economy, competition

within the industry, and the firm’scredit policy all influence a firm’sreceivables level.

What are some factors which

influence a firm’s receivables level?



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The lower the profit margin, the higher the cost of carrying receivables,because a greater portion of each

sales dollar must be financed.

The higher the cost of financing, thehigher the dollar cost.

What are some factors which

influence the dollar cost of carryingreceivables?



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What would the receivables level be at

the end of each month?

Month Sales A/RJan $100 $ 70Feb 200 160

Mar 300 250April 300 270May 200 200June 100 110

A/R = 0.7(Sales in that month) +0.2(Sales in previous month).



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What is the firm’s forecasted average

daily sales (ADS) for the first 3months? For the entire half-year?

(assuming 91-day quarters)

Avg. Daily Sales = .

1st Qtr: $600/91 = $6.59.2nd Qtr: $600/91 = $6.59.

Total sales# of days



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1st Qtr: $250/$6.59 = 37.9 days.

2nd Qtr: $110/$6.59 = 16.7 days.

What DSO is expected at the end of

March? At the end of June?

DSO = .

A/R

ADS



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Contrib. A/RMos. Sales to A/R to Sales

Jan $100 $ 0 0%

Feb 200 40 20Mar 300 210 70

End of Qtr. A/R $250 90%

Construct the uncollected balances

schedules for the end of March andJune.



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The uncollected balances schedule

gives a true picture of customers’payment patterns, even when salesfluctuate.

Any increase in the A/R to sales ratiofrom a month in one quarter to thecorresponding month in the nextquarter indicates a slowdown in

payment.

The “bottom line” gives a summary of the changes in payment patterns.



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Assume it is now July and you are

developing pro forma financialstatements for the following year.

Furthermore, sales and collections in

the first half-year matched predictedlevels. Using Year 2 sales forecasts,what are next year’s pro formareceivables levels for the end of

March and June?



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June 30

Predicted PredictedPredicted A/R to Contrib.

Mos. Sales Sales Ratio to A/RApr $400 0% $ 0May 300 20 60

June 200 70 140Projected June 30 A/R balance $200



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Cash discounts

Credit period

Credit standards

Collection policy

What four variables make up a firm’s

credit policy?



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Disregard any previous assumptions.

Current credit policy:

Credit terms = Net 30.

Gross sales = $1,000,000.80% (of paying customers) pay on

Day 30.

20% pay on Day 40.

Bad debt losses = 2% of gross sales.Operating cost ratio = 75%.

Cost of carrying receivables = 12%.



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Current:

BDLO = 0.02($1,000,000)= $20,000.

New:

BDLN = 0.01($1,100,000)= $11,000.

What are bad debt losses under the

current and the new credit policies?



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DiscountO = $0.

DiscountN = 0.6(0.02)(0.99)($1,100,000)

= $13,068.

What are the expected dollar costs of

discounts under the current and thenew policies?



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What is the incremental after-tax profit

associated with the change in creditterms?

New Old Diff.

Gross sales $1,100,000 $1,000,000 $100,000Less: Disc. 13,068 0 13,068

Net sales $1,086,932 $1,000,000 $ 86,932Prod. costs 825,000 750,000 75,000

Profit beforecredit costsand taxes $ 261,932 $ 250,000 $ 11,932

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New Old Diff.

Profit beforecredit costsand taxes $261,932 $250,000 $11,932

Credit-relatedcosts:

Carrying costs 4,068 7,890 (3,822)Bad debts 11,000 20,000 (9,000)Profit before

taxes $246,864 $222,110 $24,754

Taxes (40%) 98,745 88,844 9,902Net income $148,118 $133,266 $14,852

Should the company make the change?



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Assume the firm makes the policy

change, but its competitors react bymaking similar changes. As a result,gross sales remain at $1,000,000. How

does this impact the firm’s after -tax

profitability?



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Before the new policy change, thefirm’s net income totaled $133,266.

The change would result in a slight

gain of $134,653 - $133,266 = $1,387.



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Simple Annual Interest, 1-Year Loan

“Simple interest” means not discountor add-on.

Interest = 0.08($100,000) = $8,000.

On a simple interest loan of one year,r Nom = EAR.

.r EARNom $8,

$100,

. .000

000

0 08 8 0%

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Simple Interest, Paid Monthly

Monthly interest = (0.08/12)($100,000)= $666.67.

-100,000.00-666.67100,000

0 1 12

-667.67

N I/YR PV PMT FV

12 100000 -666.67 -100000

0.66667

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...

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r Nom = (Monthly rate)(12)= 0.66667%(12) = 8.00%.

or: 8 NOM%, 12 P/YR, EFF% = 8.30%.

Note: If interest were paid quarterly, then:

Daily, EAR = 8.33%.

EAR 1 0 084

1 8 24%.

4

. .

EAR

10 08

121 8 30%.

12.

.



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Discount Interest (Continued)

Amt. borrowed =

= = $108,696.

Amount needed1 - Nominal rate (decimal)

$100,0000.92

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Need $100,000. Offered loan with

terms of 8% discount interest, 10%compensating balance.

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Face amount of loan =

= = $121,951.

Amount needed1 - Nominal rate - CB

$100,000

1 - 0.08 - 0.1



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This procedure can handle variations.

N I/YR PV PMT FV1 100000 -109756

9.756% = EAR

0

0 1i = ?

121,951 Loan -121,951+ 12,195-109,756

-9,756 Prepaid interest-12,195 CB

100,000 Usable funds

8% Discount Interest with 10%

Compensating Balance (Continued)

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1- Year Installment Loan, 8% “Add-On”

Interest = 0.08($100,000) = $8,000.

Face amount = $100,000 + $8,000 = $108,000.

Monthly payment = $108,000/12 = $9,000.

= $100,000/2 = $50,000.

Approximate cost = $8,000/$50,000 = 16.0%.

Average loan

outstanding

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Installment Loan

To find the EAR, recognize that the firmhas received $100,000 and must makemonthly payments of $9,000. This

constitutes an ordinary annuity asshown below:

-9,000100,000

0 1 12i=?

-9,000 -9,000

Months2

...

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N I/YR PV PMT FV

12 100000 -9000

1.2043% = rate per month

0

r Nom = APR = (1.2043%)(12) = 14.45%.EAR = (1.012043)12 - 1 = 15.45%.

14.45 NOM enters nominal rate12 P/YR enters 12 pmts/yr

EFF% = 15.4489 = 15.45%.

1 P/YR to reset calculator.

ch21 cost of capital

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