Corporate Finance Test 3 – Show Work And Discuss Results

Corporate Finance Test 3 – Show work and discuss results

Analyze and discuss how a financial manager might decide whether or not to extend short-term credit to new customers to increase sales, illustrating your answer through an appropriate problem, and analyze specific financial scenarios such as a loan with a compensating balance, managing working capital, and assessing credit policy strategies.

Paper For Above instruction

In the realm of corporate finance, one of the pivotal decisions managers face is whether to extend short-term credit to new customers as a strategy to boost sales. This decision hinges on a comprehensive analysis of the associated risks and benefits, emphasizing the importance of balancing sales growth with credit risk management. Extending credit can potentially increase sales volumes and market share, especially if competitors maintain stricter credit policies. However, it also exposes the firm to higher default risks, increased collection costs, and cash flow variability. Therefore, a systematic approach that evaluates the creditworthiness of new customers, forecasts the impact on accounts receivable, and assesses the incremental profitability is essential in guiding this decision.

To illustrate this, consider a scenario where a firm evaluates an increased credit extension involving incremental sales. The first step involves estimating the additional accounts receivable generated from increased sales and understanding the associated costs, including uncollectable accounts and collection expenses. Next, the firm should analyze the incremental after-tax profit resulting from the additional sales, considering variables such as the expected default rate, collection costs, and tax effects. If the post-tax return on the incremental investment exceeds the company's required return, extending credit may be justified; otherwise, the firm should maintain its conservative credit stance.

For example, a recent case involving Henderson Office Supply demonstrates these principles. Henderson is considering liberalizing its credit policy to achieve an additional $65,000 in sales. The analysis involves estimating accounts receivable, calculating incremental return on investment, and comparing it against the company's required return of 16% on after-tax basis.

Analysis of a Corporate Loan with a Compensating Balance

In the context of corporate financing, firms often encounter loans requiring a compensating balance, which effectively raises the true interest cost. For instance, AIG needs $50 million to pay retention bonuses and takes a one-year loan with a 20% compensating balance and a 9% nominal interest rate. First, the firm must determine the actual amount borrowed to meet its cash needs, considering the compensating balance requirement. The amount to borrow is calculated as the desired cash amount divided by (1 - compensating balance percentage). Specifically, AIG should borrow:

Actual borrowings = $50 million / (1 - 0.20) = $62.5 million.

The monthly payments are based on the total amount borrowed, divided into 12 installments, ignoring interest implications for simplicity, resulting in:

Monthly payment ≈ $62.5 million / 12 ≈ $5.21 million.

However, the true cost of the loan is higher than the stated 9% due to the compensating balance requirement. Using formula 8-6, the effective interest rate can be computed, revealing that the actual cost exceeds the nominal rate, which must be carefully considered for accurate financial planning.

Managing Working Capital and Corporate Credit Policies

The statements made by the finance professor concerning working capital management warrant discussion. Firstly, the notion that having more cash on the balance sheet is inherently better is a nuanced issue. While ample cash reserves provide liquidity and buffer against uncertainties, excessive cash can indicate inefficient capital utilization, leading to lower returns (Deloof, 2003). Hence, optimal cash levels should balance liquidity needs against opportunity costs.

Secondly, the assertion that small firms are more likely to hedge against exchange rate risk than larger, multinational corporations is generally inaccurate. Larger firms tend to have more sophisticated hedging strategies and access to financial derivatives to mitigate foreign exchange risks (Madura, 2012). Small firms often lack the resources or expertise for effective hedging, relying instead on administrative or operational strategies.

Finally, the use of aging schedules to minimize ordering costs is a common inventory management technique. Proper aging schedules help identify slow-moving inventory, reducing holding costs and ordering frequency when used appropriately (Heizer & Render, 2014). This approach aids firms in balancing inventory carrying costs with the need for operational readiness.

Conclusion

Effective credit and working capital management remain crucial to corporate financial health. Deciding whether to extend credit requires analyzing potential incremental profits against risks, costs, and the firm's overall credit policy. Moreover, understanding the true cost of borrowed funds, managing liquidity efficiently, and employing strategic inventory policies can significantly influence organizational performance. These principles underscore the importance of integrated financial decision-making, balancing growth ambitions with risk mitigation to achieve sustainable success.

References

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