Question

Polymers ltd has just reviewed its credit policy and is of the view that the bad debt losses are mounting. Thus, the firm wishes to tighten its credit standards. It proposes to shorten the credit period from 45 days to 30 days. The result of this credit change is likely to reduce sales from Rs.6,00,000 to Rs.5,00,000. The bad debt losses are expected to reduce from 4% to 2% of the total sales. The collection expenses are also expected to reduce from 2% to 1% of the total sales. The firm’s variable cost ratio is 80% and it has a marginal tax rate of 40%. The post-tax cost of funds for the firm is 12%. Assuming all sales are on credit, should the firm introduce a change in credit standards?

Answer 1

Polymers ltd should not introduce the change in credit standards as it would result in a financial loss.

Step-by-step explanation:

Polymers ltd proposes to shorten its credit period from 45 days to 30 days in order to reduce bad debt losses and collection expenses. However, as a result, sales are also expected to decrease from Rs.6,00,000 to Rs.5,00,000. To determine if the firm should introduce this change in credit standards, we need to consider the financial implications.

The bad debt losses are expected to reduce from 4% to 2% of total sales, and collection expenses are expected to reduce from 2% to 1% of total sales. The firm's variable cost ratio is 80% and its marginal tax rate is 40%. The post-tax cost of funds for the firm is 12%.

To calculate the net benefit or cost of the credit policy change, we need to analyze the effect on cash flows. With the current credit period of 45 days, net sales after bad debt losses and collection expenses are: Rs.6,00,000 - (0.04 * Rs.6,00,000) - (0.02 * Rs.6,00,000) = Rs.5,40,000.

With the proposed credit period of 30 days, net sales would be: Rs.5,00,000 - (0.02 * Rs.5,00,000) - (0.01 * Rs.5,00,000) = Rs.4,95,000.

The net benefit of the credit policy change can be calculated as the difference between the net sales of the two credit periods, adjusted for the variable cost ratio and the tax rate.

The net benefit would be: (Rs.4,95,000 - Rs.5,40,000) * (1 - 0.8) * (1 - 0.4) = -Rs.6,480.

Since the net benefit is negative, it indicates a cost to the firm. Therefore, the firm should not introduce the change in credit standards as it would result in a financial loss.