Developing a credit policy is something a business eventually has to face.

One of the basic decisions you have to make when starting a business is whether or not you are going to extend credit to other businesses and consumers. This is a decision to be taken very seriously as it will impact your cash flow and even your profit. Here are six factors that you should consider when developing a credit policy and that should influence your decision whether or not to extend credit to customers. You should grant credit only if the positives of doing so outweigh the negatives. Often, this is difficult to determine.

1. The Effect on Sales Revenue

The reason you would grant credit in the first place is so your customers can delay paying you. This is convenient for your customers and will probably win customers for you, but it is not so convenient for you and your bottom line, at least on an immediate basis. Sales revenue from the sale you made to your customer will be delayed for either the discount period or the credit period, or perhaps longer if the customer is late in making the payment. The upside is that you may be able to raise your prices if you offer credit. You have a trade-off. The possibility of more customers and higher sales prices if you offer credit in exchange for possible delayed and late payments. Unfortunately, it's hard to quantify this.

2. The Effect on Cost of Goods Sold

Whether you sell products or services you have to have them available and, in the case of products, in stock, when a sale is made. When you extend credit, that means paying for that product or service in order to have it in stock but not getting paid for it immediately when it is purchased. Even though you will eventually get paid, your business has to have enough cash flow to compensate for the delayed payment. In addition, you lose any interest income you might have earned on that money. Again, you have a trade-off. This time it is more customers and higher sale prices in exchange for lost interest income and temporarily lower cash flow.

3. The Probability of Bad Debts

If a company makes all its sales for cash, there is no possibility of bad debts or debts it cannot collect. If any percentage of the company's sales are on credit, there exists the possibility of bad debts or debts you, as a business owner, will never collect. When you are developing your credit policy, you should allow for some percentage of your credit accounts that will never be paid. The trade-off here is that some percentage of your credit sales will never be paid. You have to decide if this factor is worth more customers and higher sales prices.

4. Offering a Cash Discount

Particularly when you offer credit on a business-to-business (B2B) basis, most companies offer other businesses a cash discount. In other words, if the business pays the bill within the discount period, that business gets a discount. If they don't pay within the discount period, then they must pay within the credit period or the original period within which the bill is due. Cash discounts are often stated like this example: 2/10, net 30. If those are your credit terms, it means that you offer a 2% discount if the bill is paid in 10 days. If you don't take the discount, the bill is due within the 30 day credit period. Is getting your money in 10 days worth the 2% discount that you offer? That's the tradeoff you have regarding cash discounts and whether you should offer them.

5. Taking on Debt
If you, as a business owner, decide to offer credit to your customers, chances are you will have to take on debt to finance your accounts receivables. As a small business, you may not be able to afford to sell your products or services without immediate payment unless you have a good working capital base. If you have to take on debt, you have to factor in the cost of short-term borrowing as part of your decision to offer credit. Offering credit to your customers is a big decision with wide-reaching effects for your company. You have to consider the factors above and more. Will offering credit result in repeat business? Do you have the time and resources to collect late payments? Make this decision wisely.

Inventory Accounting Methods

An Overview of the Three Most Common Inventory Valuation Methods

Aug 28, 2008 Diane White

Adding It All Up - moderncog

Almost every company has some type of inventory. Here are three of the most common ways to account for this inventory -- FIFO,LIFO, and the Average Cost Method. Inventories are items that a company holds for sale, or items that will be used to manufacture products that will be sold. The method that a company uses to account for its inventory determines the amount of expense recognized for cost of goods sold on the financial statement as well as the value of inventory recognized on the balance sheet. The three most commonly used methods are First-in, First Out (FIFO), Last-in, First-out (LIFO), and the average cost method.

Examples of FIFO, LIFO, and the Average Cost Method

Because identical inventory items can be acquired for different costs during the same accounting period, it is necessary to determine a unit cost using one of these cost flow assumptions. When FIFO is used, the first unit purchased is the cost of the first unit sold; therefore the ending inventory will be made up of the most recently purchased units. When LIFO is used, the last unit purchased is the cost of the first unit sold; therefore the ending inventory with this method is made up of the earliest units purchased. The average cost method is an average of all the costs; therefore the ending inventory balance is an average of the purchase costs.
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An example can illustrate the difference between the three methods. A new company purchases four identical units in one month.

1 unit purchased on the 10th of the month at a cost of $10 1 unit purchased on the 16th of the month at a cost $12 1 unit purchased on the 20th of the month at a cost of $13 1 unit purchased on the 30th of the month at a cost of $14

If one item is sold for $25 using the FIFO method, the cost of goods sold would be $10, profit would be $15($25-$10), and ending inventory balance would be $39 ($12+$13+$14).

Popular topics

Accounting 101 Inventory Valuation Methods Inventory Or Stock Valuation Understanding LIFO and FIFO Methods of Inventory Valuation

If one item were sold for $25 using the LIFO method, the cost of goods sold would be $14, profit would be $11($25-$14), and ending inventory balance would be $35($10+$12+$13).

Using the average cost method, if one item were sold for $25, the cost of goods sold would be $12.25($10+$12+$13+$14/4), profit would be $12.75, and ending inventory balance would be $36.75 (average cost per unit $12.25 x 3 remaining units).

Effects of FIFO, LIFO, and the Average Cost Method

As you can see by these examples, each method has a different effect on both profit and ending inventory values. The FIFO method has the lowest cost of goods sold, the highest profit, and the highest ending inventory balance. The LIFO method has the highest cost of goods sold, the lowest profit, and the lowest ending inventory balance. The average cost method falls in between the other two methods.

Effects of Inflation
If prices were constant during the period, all three methods would produce the exact same result since each unit would have been purchased for an identical amount. But, since prices usually change, each method will produce different results. During periods of inflation, LIFO will generate a lower amount of gross profit and a lower inventory value. The FIFO method will produce a higher gross profit and a higher ending inventory balance. During periods of inflation, LIFO offers substantial tax savings due to lower profits and lower inventories. However, in periods of deflation, the effects are just the opposite. This is just a brief overview of some commonly used methods for valuing inventory. Inventory valuation methods have a significant impact on a company's income statement and balance sheet. Before deciding which method to use, please consult with a knowledgeable accountant or CPA. More information about these methods can be found at

Read more at Suite101: Inventory Accounting Methods: An Overview of the Three Most Common Inventory Valuation Methods | Suite101.com http://dianewhite.suite101.com/inventory-accounting-methods-a66308#ixzz1uXaKEuAq

9.3.2

Modigliani and Miller Approach

The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.

Assumption of the MM approach The MM approach to irrelevance of dividend is based on the following assumptions:

The capital markets are perfect and the investors behave rationally. All information is freely available to all the investors. There is no transaction cost. Securities are divisible and can be split into any fraction. No investor can affect the market price. There are no taxes and no flotation cost. The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.

The model Under the assumptions stated above, MM argue that neither the firm paying dividends nor the shareholders receiving the dividends will be adversely affected by firms paying either too little or too much dividends. They have used the arbitrage process to show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders. They have shown that given the investment opportunities, a firm will finance these either by ploughing back profits of if pays dividends, then will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally. In order to satisfy their model, MM has started with the following valuation model. P0= 1* (D1+P1)/ (1+ke)

Where, P0 = Ke = Present market price of the share Cost of equity share capital

D1 = P1 =

Expected dividend at the end of year 1 Expected market price of the share at the end of year 1

With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:

Payment of dividend by the firm Rising of fresh capital.

With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralised by the decrease in terminal value of the share. The working of the arbitrage process is substantiated as follows: Suppose a firm has 100000 shares outstanding and is planning to declare a dividend of $5 at the end of current financial year. The present market price of the share is $100. The cost of equity capital, ke, may be taken at 10%. The expected market price at the end of the year 1 may be found under two options:

If dividend of $5 is paid If dividend is not paid

When Dividend of $5 is paid (the value of D1 is 5) : P0 = (D1 + P1)/ (1+ ke)

P0 (1+ ke) = D1 + P1 P1 = = = P0 (1+ ke) D1 100(1.10) 5 105

So, the market price is expected to be $105, if the firm pays dividend of $5 When, Dividend of $5 is not pain (the value of D1 is 0): P0 = (D1 + P1)/ (1+ ke)

P0 (1+ ke) = D1 + P1 P1 = P0 (1+ ke) D1

= =

100(1.1) 110

So, the market price of the share is expected to be $110, if the firm does not pay any dividend. However, in both the cases, the position of the shareholders would be the same. A shareholder having for example 1 share will be having same worth of his holding if the firm pays dividend or not. In case, the dividend of $5 is paid, he will receive $5 from the firm as dividend and the market price of the share would be $105, giving a total worth of $110. In case, the dividend is not paid then the market price of the share or the worth of the shareholder would be still $110. So, the shareholder would be indifferent if dividend is paid or not to him. The same example can be extended further to analyze the effect of arbitrage employed by the firm. Say, the firm has total profits of $1000000 during the year 1 and is planning to make an investment of $2000000 at the end of the year 1. The arbitrage process and value of the firm may be explained as follows:

If dividend of $5 is paid by the firm at the end of year 1: $1000000 $500000 $500000 $2000000 $1500000 $105 14285.71 114285.71

Total Earnings Dividends Paid (100000 * $5) Retained Earnings Total funds required for investment Therefore, fresh capital to be issued Market price at the end of year 1 Number of shares to be issued (1500000/105) Total number of shares (100000+14285.71) Applying the formula, the value of the firm, nP0 is nP0 = = =

[(n + m)P1 I +E] / (1+ ke) [(114285.71)105 2000000 + 1000000] / (1.10) $10000000 If dividend of $5 is not paid by the firm at the end of the year 1:

Total earnings Dividends Paid Retained Earnings Total funds required for investment Therefore, fresh capital to be issued Market price at the end of year 1 Number of share to be issued (1000000/110) Total number of shares (100000+9090.0) Applying the formula, the value of the firm, nP0 is nP0 = = = [(n + m) P1 I +E] / (1+ ke)

$1000000 $1000000 $2000000 $1000000 $110 9090.9 109090.9

[(109090.9)110 2000000 + 1000000] $10000000

So, the value of the firm remains same at $10000000 if the dividend is paid or not. With the help of above process, it can be showed that dividend policy is irrelevant for the valuation of the firm. Dividend payment does not affect the value of the firm. It should be noted that, the formula used above, gives the current market value of the firm. The MM model shows that if dividend is paid or not at the end of current year, the present market value of the firm remains same at $10000000. The same example can be applied to find out the expected market value of the firm at the end of current year as follows:

If dividend of $5 is paid 114285.71 $105 $12000000

Total number of shares Market price Total market value

If dividend of $5 is not paid 109090.90 $110

Total number of shares Market price

Total market value

$12000000

Thus, the expected market value remains same at $12000000, whether the firm pays dividend of $5 or not. The MM Model shows therefore, that the current market value or the expected market value of the firm, both are unaffected by the dividend decision of the firm. Critical Appraisal Under the assumptions set by MM, this model testifies that dividend is irrelevant and the investors are indifferent between the current dividends and the future capital gains. Given these assumptions, the effect of a dividend decision may be stated as: that there is not relationship between dividend policy and value of the share. One dividend policy is as good as other. Investors are concerned only with the total returns and are indifferent if these returns are from dividend income or capital gains. That is, to finance the growth, the firm may choose to issue shares and thereby allowing profits to be used to pay dividend, or may use internally generated funds for financing the growth and thereby paying less in dividends and not issuing any shares. Jump to: navigation, search The ModiglianiMiller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the ModiglianiMiller theorem is also often called the capital structure irrelevance principle. Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions. Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."

Contents
[hide]

1 Historical background o 1.1 Without taxes o 1.2 With taxes 2 Notes 3 References 4 External links

[edit] Historical background

Miller and Modigliani derived the theorem and wrote their groundbreaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem. = Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The ModiglianiMiller theorem states that the value of the two firms is the same.

[edit] Without taxes

Proposition I: where is the value of an unlevered firm = price of buying a firm composed only of equity, and is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning.[2] To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt. This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile to the firm. Proposition II:.

Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant.

is the required rate of return on equity, or cost of equity. is the company unlevered cost of capital (ie assume no leverage). is the required rate of return on borrowings, or cost of debt. is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC). These propositions are true assuming the following assumptions:

no transaction costs exist, and individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

[edit] With taxes

Proposition I:

where

is the value of a levered firm. is the value of an unlevered firm. is the tax rate ( ) x the value of debt (D) the term assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are nondeductible. Proposition II:

where

is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium. is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0). is the required rate of return on borrowings, or cost of debt. is the debt-to-equity ratio. is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100% The following assumptions are made in the propositions with taxes:

corporations are taxed at the rate on earnings after interest, no transaction costs exist, and individuals and corporations borrow at the same rate

Miller and Modigliani published a number of follow-up papers discussing some of these issues. The theorem was first proposed by F. Modigliani and M. Miller in 1958. Net Income (NI) Approach

Net Income theory was introduced by David Durand. According to this approach, the capital structure decision is relevant to the valuation of the firm. This means that a change in the financial leverage will automatically lead to a corresponding change in the overall cost of capital as well as the total value of the firm. According to NI approach, if the financial leverage increases, the weighted average cost of capital decreases and the value of the firm and the market price of the equity shares increases. Similarly, if the financial leverage decreases, the weighted average cost of capital increases and the value of the firm and the market price of the equity shares decreases. Assumptions of NI approach:

1. There are no taxes 2. The cost of debt is less than the cost of equity. 3. The use of debt does not change the risk perception of the investors

Example A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and the cost of equity is 12.5(ke)%. Calculation of the Value of the firm:

Effect of change in the capital structure: (Increase in debt capital) Let us assume that the firm decides to retire $100,000 worth of equity by using the proceeds of new debt issue worth the same amount. The cost of debt and equity would remain the same as per the assumptions of the NI approach. This is because one of the assumptions is that the use of debt does not change the risk perception of the investors.

Calculation of new value of the Firm

Please note: Overall cost of capital can also be calculated by using the weights of debt and equity contents with the respective cost of capitals. This proves that the use of additional financial leverage (debt) causes the value of the firm to increase and the overall cost of capital to decrease.

Developing a Credit Policy

Five Factors to Consider when Deciding Whether or Not to Extend Credit
By Rosemary Peavler, About.com Guide
See More About:

accounts receivable credit policy discount period interest rates

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Villas-Bannerghatta Ext.Clubhouse, Swimming Pool, Gym Prices starting Rs. 39.95 LakhsArthaproperty.com/Bangalore Top B schools in indiaWLC College: Work & Study together UK Diploma,16 SuperSpecialisationwww.wlcibusiness.in Developing a credit policy is something a business eventually has to face. One of the basic decisions you have to make when starting a business is whether or not you are going to extend credit to other businesses and consumers. This is a decision to be taken very seriously as it will impact your cash flow and even your profit. Here are six factors that you should consider when developing a credit policy and that should influence your decision whether or not to extend credit to customers. You should grant credit only if the positives of doing so outweigh the negatives. Often, this is difficult to determine.

1. The Effect on Sales Revenue

The reason you would grant credit in the first place is so your customers can delay paying you. This is convenient for your customers and will probably win customers for you, but it is not so convenient for you and your bottom line, at least on an immediate basis. Sales revenue from the sale you made to your customer will be delayed for either the discount period or the credit period, or perhaps longer if the customer is late in making the payment. The upside is that you may be able to raise your prices if you offer credit. You have a trade-off. The possibility of more customers and higher sales prices if you offer credit in exchange for possible delayed and late payments. Unfortunately, it's hard to quantify this.

2. The Effect on Cost of Goods Sold

Whether you sell products or services you have to have them available and, in the case of products, in stock, when a sale is made. When you extend credit, that means paying for that product or service in order to have it in stock but not getting paid for it immediately

when it is purchased. Even though you will eventually get paid, your business has to have enough cash flow to compensate for the delayed payment. In addition, you lose any interest income you might have earned on that money. Again, you have a trade-off. This time it is more customers and higher sale prices in exchange for lost interest income and temporarily lower cash flow.

3. The Probability of Bad Debts

If a company makes all its sales for cash, there is no possibility of bad debts or debts it cannot collect. If any percentage of the company's sales are on credit, there exists the possibility of bad debts or debts you, as a business owner, will never collect. When you are developing your credit policy, you should allow for some percentage of your credit accounts that will never be paid. The trade-off here is that some percentage of your credit sales will never be paid. You have to decide if this factor is worth more customers and higher sales prices.

4. Offering a Cash Discount

Particularly when you offer credit on a business-to-business (B2B) basis, most companies offer other businesses a cash discount. In other words, if the business pays the bill within the discount period, that business gets a discount. If they don't pay within the discount period, then they must pay within the credit period or the original period within which the bill is due. Cash discounts are often stated like this example: 2/10, net 30. If those are your credit terms, it means that you offer a 2% discount if the bill is paid in 10 days. If you don't take the discount, the bill is due within the 30 day credit period. Is getting your money in 10 days worth the 2% discount that you offer? That's the tradeoff you have regarding cash discounts and whether you should offer them.

5. Taking on Debt
If you, as a business owner, decide to offer credit to your customers, chances are you will have to take on debt to finance your accounts receivables. As a small business, you may not be able to afford to sell your products or services without immediate payment unless you have a good working capital base. If you have to take on debt, you have to factor in the cost of short-term borrowing as part of your decision to offer credit. Offering credit to your customers is a big decision with wide-reaching effects for your company. You have to consider the factors above and more. Will offering credit result in repeat business? Do you have the time and resources to collect late payments? Make this decision wisely.