NOTES

Trade Discount: It is deducted from the invoice value and the net amount is accounted as sale or
purchase. Therefore it is not accounted in the books.

Cash Discount: It is available when the payment is made on or before a specifice period. Eg.
1/10 net 45
It means you get one percent if you pay with in 10 days (i.e 35 days before the due date)
otherwise you have to pay the total amount

Effective Interest for seller will be 1/35*365 = 10.43%

From the point of view of the payer i.e buyer he get 1% against payment of 99

His effective interest will = 10.43/.99 =10.53%

** Seller lose 1 out of 100 buyer gains 1 for payment of 99 ( 1 out of 99)

CREDIT DECISION

Change in the credit norms will either increase the sale or reduce the sale i.e increase or decrease
contribution

Increase in sale(contribution) may result in increase in receivable, bad debt and discount
Decision is to be taken based on the residual income taking into account the opportunity cost of
increase in receivable, resultant increase in discount and bad debt

Decrease in sale may see a reduction in contribution and also savings in receivable, bad debt and
discount
Pl note that only incremental values are to be considered and Fixed cost which has no relevance
is ignored.

Please read the slides . Format is available

E.g. A Ltd is contemplating to liberalize its collection efforts. Its present sales are Rs. 10 lakhs,
its average collection period is 30 days, its expected variable cost to sales ratio is 85 per cent and
its bad debt ratio is 5%. The company’s cost of capital is 12 per cent and tax rate is 20 per cent.
The proposed liberalization is collection effort increases sales to Rs. 12 lakhs, increases average
collection period, by 15 days, and increases the bad debt ratio to 6%.(Total Sale) Determine the
residual income

Increase in sale 2,00,000

Contribution 30,000

Less: Increase in Bad Debt Old 5% of 10 lacs 50,000

PBT 8,000
Less Tax 1,600
PAT 6,400 A

Amount blocked in receivable

Old Sale for 15 days 10,00,000/365*15 41,096

Less opportunity cost 12% of 62054 7,447 B

Residual Income A-B (1047)

SINCE RESIDUAL INCOME IS NEGATIVE THE PRPOSAL SHOULD BE DROPPED.

Note: Receivable of the old sale including the profit would have received 15 ago
But in the case of new sale only the cost of goods sold is blocked for 45 days
 For you to do:

I.. Current sale of X Ltd is 20,000 crores. It bad debts are to the tune of 2%. The company has a
contribution margin of 45%. The existing fixed cost is Rs 3000 crores which will remain in the
coming period.The current cash discount of 1.5/10, net 50, being availed by 50% of its
customers. The cost of capital is 20%. The company is considering the following 3 options

1. Increase the credit period to sixty days. This expected to increase the sale by 20% and
bad debt to 3%. An incremental investment of Rs 600 crores in inventory will be
required
2. Offer cash discount term 2/10,net 30. This is expected to increase sale by 5%. It is
estimated that 50% of the customers will avail of the cash discount. This will result in a
decrease in bad debts to 1.5%
3. Offer both extended credit of 60 days and as well as cash discount, terms of which are
1.5/10, net 60. The estimated incremental sale will be 20%. It is estimated that 40 per
cent of the customers would avail cash discount. Due to more lenient credit terms bad
debts are expected to increase to 3%. The incremental investment in working capital(with
out taking into account the effect on debtors) is Rs 600 crores

Prepare a table showing the calculation of pre tax profit under the above 3 options.

II. X Ltd, has a annual credit sales of Rs 150 crores. Company’s existing credit terms are 1/15,
net 40. Generally 60% of the customers avail cash discount.The average period is 45 days and
contribution margin is 30%. Percentage of default rate is 0.5%. Company
has a contribution margin of 30% The company is thinking of two alternative changes in credit
terms:

Credit Terms Percentage taking Collection period Default percentage

2/10, net 35 80 20 1.00

3/10, net 25 95 14 1.5

Tax rate is 30% and required rate of return is 18%

What strategy should be followed by the company if sales are expected to remain stable?
Tabulate the residual income under all three credit terms
III. “2/10, net 30” is the present credit term of Welldone Ltd, Its present level of sales is
Rs. 6, 00,000, with an average collection period of 30 days. The contribution margin ratio is 15
per cent.
The proportion of sales on which currently customers take discount is 1 per cent. The company’s
cost of capital is 10 per cent. Now the company is considering to increase the discount term to
“4/10, net 30”, which is expected to push up sales to Rs. 6,50,000 and reduce the average
collection period by 10 days. Such relaxation increases the proportion of discount sales to 2 per
cent. Determine the residual income with the assumption of 40 per cent tax rate.

IV. Prosperous Ltd present credit sale is 150 lacs with credit term of 2/10 net 30.
Presently 2% of the customers avail discount facility and 1% of the total sale is bad
debt. The company is contemplating to enhance credit term to 3/10 net 45. In that event
sales of the company will increase by 20% and bad debt on the total sale will be 2%.
Customers availing discount will be 3 %. The contribution margin is 20% and income tax
is rate 30% Cost of capital is 15%. Advise the company. What will be the residual
income

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