CREDIT POLICY AT BRAAM INDUSTRIES

Tricia Haltiwinger, the president of Braam Industries, has been exploring ways of
improving the company’s financial performance. Braam Industries manufactures
and sells office equipment to retailers. The company’s growth has been relatively
slow in recent years, but with an expansion in the economy, it appears that sales
may increase more quickly in the future. Tricia has asked Andrew Preston, the
company’s treasurer, to examine Braam’s credit policy to see if a different credit
policy can help increase profitability.
The company currently has a policy of net 30. As with any credit sales, default
rates are always of concern. Because of Braam’s screening and collection process,
the default rate on credit is currently only 1.5 percent. Andrew has examined the
company’s credit policy in relation to other vendors, and he has determined that
three options are available.
The first option is to relax the company’s decision on when to grant credit. The
second option is to increase the credit period to net 45, and the third option is a
combination of the relaxed credit policy and the extension of the credit period to
net 45. On the positive side, each of the three policies under consideration would
increase sales. The three policies have the drawbacks that default rates would
increase, the administrative costs of managing the firm’s receivables would
increase, and the receivables period would increase. The credit policy change
would impact all four of these variables in different degrees. Andrew has prepared
the following table outlining the effect on each of these variables:

Annual Sales Default Rate Administrative Costs Receivables

Option 1 158 2.90 2.70 41

Option 2 149 2.20 1.90 51

Option 3 167 2.50 2.10 49

Braam’s variable costs of production are 45 percent of sales, and the relevant
interest rate is a 6 percent effective annual rate. Which credit policy should the
company use? Also, notice that in option 3 the default rate and administrative
costs are below those in option 2. Is this plausible? Why or why not?
Step 1 of 1
To decide on the optimal credit policy, we need to calculate the NPV of each
policy, We will begin with the calculation of the NPV of the current policy.

Current Policy
First, we need to calculate the average daily sales which are:

Average daily sales = $140,000,000/365

Average daily sales = $383,561.64

Next, we need the average daily costs. We will begin with the average daily
variable costs, which are 45 percent of sales. So, the average daily variable costs
are:

Average daily variable costs = 0.45($140,000,000/365)

Average daily variable costs = $172,602.74

Under the current policy, the default rate is 1.9 percent, so the average daily
defaults will be:

Average daily defaults = 0.019($140,000,000/365)

Average daily defaults = $7,287.67

The current policy has administrative costs equal to 1.6 percent of sales, so the
average daily administrative costs are:

Average daily administrative costs = 0.016($140,000,000/365

Average daily administrative costs = $6,136.99

We also need the appropriate interest rate for the collection period. With a 6
percent annual interest rate, the periodic rate for the 38 day collection period is:

Interest rate = (1 + .06/365)38 − 1

Since the credit policy will exist into perpetuity, the NPV is:

NPV = −$172,602.74 + ($383,561.64 − 172,602.74 − 7,287.67 − 6,136.99) /

Option 1
Under Option 1, the average daily sales are:

Average daily sales = $158,000,000/365

Average daily sales = $432,876.71

Average daily variable costs = 0.45($158,000,000/365)

Average daily variable costs = $194,794.52

Under the Option 1, the default rate is 2.9 percent, so the average daily defaults
will be:

Average daily defaults = 0.029($158,000,000/365)

Average daily defaults = $12,553.42

Option 1 has administrative costs equal to 2.7 percent of sales, so the average
daily administrative costs are:

Average daily administrative costs = 0.027($158,000,000/365)

Average daily administrative costs = $11,687.67

We also need the appropriate interest rate for the collection period. With a 6
percent annual interest rate, the periodic rate for the 41 day collection period is:

Interest rate = (1 + .06/365)41 – 1

Since the credit policy will exist into perpetuity, the NPV is:

NPV = –$194,794.52 + ($432,876.71 – 194,794.52 – 12,553.42 – 11,687.67) /

NPV = $32,369,467.12

Option 2
Under Option 2, the average daily sales are:

Average daily sales = $149,000,000/365

Average daily sales = $408,219.18

The average daily variable costs will be:

Average daily variable costs = 0.45($149,000,000/365)

Average daily variable costs = $183,698.63

Under the Option 2, the default rate is 2.2 percent, so the average daily defaults
will be:

Average daily defaults = 0.022($149,000,000/365)

Option 2 has administrative costs equal to 1.9 percent of sales, so the average
daily administrative costs are:

Average daily administrative costs = 0.019($149,000,000/365)

Average daily administrative costs = $7,756.16

We also need the appropriate interest rate for the collection period. With a 6
percent annual interest rate, the periodic rate for the 51 day collection period is:

Interest rate = (1 + .06/365)51 – 1

Since the credit policy will exist into perpetuity, the NPV is:

NPV = –$183,698.63 + ($408,219.18 – 183,698.63 – 8,980.82 – 7,756.16) /

NPV = $25,233,509.84

Option 3
Under Option 3, the average daily sales are:

Average daily sales = $167,000,000/365

Average daily sales = $457,534.25

The average daily variable costs will be:

Average daily variable costs = 0.45($167,000,000/365)

Average daily variable costs = $205,890.41

Under the Option 3, the default rate is 2.5 percent, so the average daily defaults
will be:

Average daily defaults = 0.025($167,000,000/365)

Average daily defaults = $11,438.36

Option 3 has administrative costs equal to 2.1 percent of sales, so the average
daily administrative costs are:

Average daily administrative costs = 0.021($167,000,000/365)

Average daily administrative costs = $9,608.22

We also need the appropriate interest rate for the collection period. With a 6
percent annual interest rate, the periodic rate for the 49 day collection period is:
Interest rate = (1 + .06/365)49 – 1
Interest rate = 0.00785 or 0.785%

Since the credit policy will exist into perpetuity, the NPV is:

NPV = –$205,890.41 + ($457,534.25 – 205,890.41 – 11,438.36 – 9,608.22 /

NPV = $29,158,049.54

The company should choose Option 1 since it has the highest NPV. The default
rate and administrative costs of Option 2 are below those of Option 3. This is
plausible. Option 2 extends the credit period, while Option 3 extends the credit
period and relaxes the credit policy. The relaxation of the credit policy will
increase the default rate since it will include companies with lower credit ratings
who are less likely to pay. This in turn will increase the administrative costs of
managing the delinquent accounts.