PART IX Financial Planning and Short-Term Management
to such an operation, and the factor typically charges a fee of 1 to 2 percent of the value of the invoice.15
This factoring arrangement, known as maturity factoring, provides assistance with collection and insurance against bad debts. Generally, the factor is also willing to advance 70 to 80 percent of the value of the accounts at an interest cost of 2 or 3 percent above the prime rate. Factoring that provides collection, insurance, and finance is generally termed old-line factoring.16
Factoring is most common in industries such as clothing and toys. These industries are characterized by many small producers and retailers that do not have longestablished relationships with each other. Because a factor may be employed by a number of manufacturers, it sees a larger proportion of the transactions than any single firm and therefore is better placed to judge the creditworthiness of each customer.17
If you don’t want help with collection but do want protection against bad debts, you can obtain credit insurance. The credit insurance company obviously wants to be certain that you do not throw caution to the winds by extending boundless credit to the most speculative accounts. It therefore generally imposes a maximum amount that it will cover for accounts with a particular credit rating. Thus it may agree to insure up to a total of $100,000 of sales to customers with the highest Dun and Bradstreet rating, up to $50,000 to those with the next-highest rating, and so on. You may claim not only if the customer actually becomes insolvent but also if an account is overdue. Such a delinquent account is then turned over to the insurance company, which makes vigorous efforts to collect.
Most governments have established agencies to insure export credits. In the United States this insurance is provided by the Export–Import Bank (Ex–Im Bank) in association with a group of insurance companies known as the Foreign Credit Insurance Association (FCIA). Banks are much more willing to lend against export credits that have been insured.
15Many factors are subsidiaries of commercial banks. Their typical client is a relatively small manufacturing company selling on a repetitive basis to a large number of industrial or retail customers.
16Under an arrangement known as with-recourse factoring, the company is liable for any delinquent accounts. In this case the factor provides collection, but not insurance.
17This point is made in S. L. Mian and C. W. Smith, Jr., “Accounts Receivable Management Policy: Theory and Evidence,” Journal of Finance 47 (March 1992), pp. 169–200.
SUMMARY
Credit management involves five steps. The first is to establish normal terms of
sale. This means that you must decide the length of the payment period and the
size of any cash discounts. In most industries these conditions are standardized.
The second step is to decide the form of the contract with your customer. Most
domestic sales are made on open account. In this case the only evidence that the
customer owes you money is the entry in your ledger and a receipt signed by the
customer. Particularly if the customer is located in a foreign country, you may re-
quire a more formal contract. We looked at two such devices—the trade acceptance
and the letter of credit.
The third step is to assess each customer’s creditworthiness. There are a variety of
sources of information—your own experience with the customer, the experience of
other creditors, the assessment of a credit agency, a check with the customer’s bank,
the market value of the customer’s securities, and an analysis of the customer’s fi-
CHAPTER 32 Credit Management
921
nancial statements. Firms that handle a large volume of credit information often use a formal system for combining the data from various sources into an overall credit score. Such numerical scoring systems help separate the borderline cases from the obvious sheep or goats. We showed how you can use statistical techniques such as multiple-discriminant analysis to give an efficient measure of default risk.
When you have made an assessment of the customer’s credit standing, you can move to the fourth step in credit management, which is to establish sensible credit limits. The job of the credit manager is not to minimize the number of bad debts; it is to maximize profits. This means that you should increase the customer’s credit limit as long as the probability of payment times the expected profit is greater than the probability of default times the cost of the goods. Remember not to be too shortsighted in reckoning the expected profit. It is often worth accepting the marginal applicant if there is a chance that the applicant may become a regular and reliable customer.
The fifth, and final, step is to collect. Doing so requires tact and judgment. You want to be firm with the truly delinquent customer, but you don’t want to offend the good one by writing demanding letters just because a check has been delayed in the mail. You will find it easier to spot troublesome accounts if you keep a careful record of the aging of receivables.
These five steps are interrelated. For example, you can afford more liberal terms of sale if you are very careful about whom you grant credit to. You can accept higher-risk customers if you are very active in pursuing any late payers. A good credit policy is one that adds up to a sensible whole.
A standard text on the practice and institutional background of credit management is:
R. H. Cole and L. Mishler: Consumer and Business Credit Management, 11th ed., McGraw-Hill, New York, 1998.
For a more analytical discussion of credit policy, see:
S.Mian and C. W. Smith: “Extending Trade Credit and Financing,” Journal of Applied Corporate Finance, 7:75–84 (Spring 1994).
M. A. Peterson and R. G. Rajan: “Trade Credit: Theories and Evidence,” Review of Financial Studies, 10:661–692 (1997).
Altman’s paper is the classic on numerical credit scoring:
E.I. Altman: “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,” Journal of Finance, 23:589–609 (September 1968).
Altman also provides a review of credit scoring models in:
E. I. Altman: Corporate Financial Distress and Bankruptcy, 2nd ed., John Wiley, New York, 1993.
FURTHER READING
1. Company X sells on a 1/30, net 60 basis. Customer Y buys goods invoiced at $1,000.
QUIZ
a.How much can Y deduct from the bill if Y pays on day 30?
b.What is the effective annual rate of interest if Y pays on the due date rather than on day 30?
c.How would you expect payment terms to change if
i.The goods are perishable.
ii.The goods are not rapidly resold.
iii.The goods are sold to high-risk firms.
2.The lag between the purchase date and the date on which payment is due is known as the terms lag. The lag between the due date and the date on which the buyer actually
922
PART IX Financial Planning and Short-Term Management
pays is the due lag, and the lag between the purchase and actual payment dates is the pay lag. Thus,
Pay lag terms lag due lag
State how you would expect the following events to affect each type of lag:
a.The company imposes a service charge on late payers.
b.A recession causes customers to be short of cash.
c.The company changes its terms from net 10 to net 20.
3.Complete the passage below by selecting the appropriate terms for each blank from the following list (some terms may be used more than once): acceptance, open, commercial, trade, the United States, his or her own, draft, account, bank, the customer’s, letter of credit, shipping documents.
Most goods are sold on ______ ______. In this case the only evidence of the debt is a record in the seller’s books and a signed receipt. If you wish to ensure that its buyer will pay, you can arrange a(n) ______ ______ , ordering payment by the customer. In order to obtain the ______ ______, the customer must acknowledge this order and sign the document. The signed acknowledgment is known as a(n) ______ ______. Sometimes the seller may ask ______ ______ bank to sign the document. In this case it is known as a(n) ______ ______. The fourth form of contract is used principally in overseas trade. The customer’s bank sends the exporter a(n) ______ ______ ______ stating that it has established a credit in his or her favor at a bank in the United States. The exporter then draws a draft on ______ bank and presents it to ______ ______ bank together with the
______ ______ and ______ ______. The bank then arranges for this draft to be accepted and forwards the ______ ______ to the customer’s bank.
4.The Branding Iron Company sells its irons for $50 apiece wholesale. Production cost is $40 per iron. There is a 25 percent chance that wholesaler Q will go bankrupt within the next year. Q orders 1,000 irons and asks for six months’ credit. Should you accept the order? Assume that the discount rate is 10 percent per year, there is no chance of a repeat order, and Q will pay either in full or not at all.
5.Look back at Section 32.4. Cast Iron’s costs have increased from $1,000 to $1,050. Assuming there is no possibility of repeat orders, answer the following:
a.When should Cast Iron grant or refuse credit?
b.If it costs $12 to determine whether a customer has been a prompt or slow payer in the past, when should Cast Iron undertake such a check?
6.Look back at the discussion in Section 32.4 of credit decisions with repeat orders. If p1 .8, what is the minimum level of p2 at which Cast Iron is justified in extending credit?
7.True or False?
a.Exporters who require greater certainty of payment arrange for the customers to sign a bill of lading in exchange for a sight draft.
b.Multiple-discriminant analysis is often used to construct an index of creditworthiness. This index is generally called a Z score.
c.It makes sense to monitor the credit manager’s performance by looking at the proportion of bad debts.
d.If a customer refuses to pay despite repeated reminders, the company will usually turn the debt over to a factor or an attorney.
e.The Foreign Credit Insurance Association insures export credits.
PRACTICE QUESTIONS
1.Listed below are some common terms of sale. Can you explain what each means?
a.2/30, net 60.
b.net 10.
c.2/5, EOM, net 30.
CHAPTER 32 Credit Management
923
2.Some of the items in question 1 involve a cash discount. For each of these, calculate the rate of interest paid by customers who pay on the due date instead of taking the cash discount.
3.Phoenix Lambert currently sells its goods cash on delivery. However, the financial manager believes that by offering credit terms of 2/10 net 30 the company can increase sales by 4 percent, without significant additional costs. If the interest rate is 6 percent and the profit margin is 5 percent, would you recommend offering credit? Assume first that all customers take the cash discount. Then assume that they all pay on day 30.
4.As treasurer of the Universal Bed Corporation, Aristotle Procrustes is worried about his bad debt ratio, which is currently running at 6 percent. He believes that imposing a more stringent credit policy might reduce sales by 5 percent and reduce the bad debt ratio to 4 percent. If the cost of goods sold is 80 percent of the selling price, should Mr. Procrustes adopt the more stringent policy?
5.Jim Khana, the credit manager of Velcro Saddles, is reappraising the company’s credit
policy. Velcro sells on terms of net 30. Cost of goods sold is 85 percent of sales, and fixed
EXCEL
costs are a further 5 percent of sales. Velcro classifies customers on a scale of 1 to 4. Dur-
ing the past five years, the collection experience was as follows:
Defaults as Percent
Average Collection Period in Days
Classification
of Sales
for Nondefaulting Accounts
1
.0
45
2
2.0
42
3
10.0
40
4
20.0
80
The average interest rate was 15 percent.
What conclusions (if any) can you draw about Velcro’s credit policy? What other factors should be taken into account before changing this policy?
6.Look again at question 5. Suppose (a) that it costs $95 to classify each new credit applicant and ( b) that an almost equal proportion of new applicants falls into each of the four categories. In what circumstances should Mr. Khana not bother to undertake a credit check?
7.Until recently, Augean Cleaning Products sold its products on terms of net 60, with an
average collection period of 75 days. In an attempt to induce customers to pay more
EXCEL
promptly, it has changed its terms to 2/10, EOM, net 60. The initial effect of the changed
terms is as follows:
Average Collection Periods, Days
Percent of Sales with Cash Discount
Cash Discount
Net
60
30*
80
*Some customers deduct the cash discount even though they pay after the specified date.
Calculate the effect of the changed terms. Assume
•Sales volume is unchanged.
•The interest rate is 12 percent.
•There are no defaults.
•Cost of goods sold is 80 percent of sales.
8.Look back at question 7. Assume that the change in credit terms results in a 2 percent increase in sales. Recalculate the effect of the changed credit terms.
9.Financial ratios were described in Chapter 29. If you were a credit manager, to which financial ratios would you pay most attention? Which do you think would be the least informative?
924PART IX Financial Planning and Short-Term Management
10.Discuss the problems with developing a numerical credit scoring system for evaluating personal loans. You can only test your system using data for applicants who have in the past been granted credit. Is this a potential problem?
11.Discuss ways in which real-life decisions are more complex than the decision illustrated in Figure 32.3. How do you think these differences ought to affect the credit decision?
12.How should your willingness to grant credit be affected by differences in (a) the profit margin, (b) the interest rate, (c) the probability of repeat orders? In each case illustrate your answer with a simple example.
13.Select two companies from the Market Insight database (www.mhhe.com/ edumarketinsight). Use their latest financial statements to calculate some financial ratios that throw light on their relative creditworthiness. Calculate a Z-score for each, using the formula shown in Section 32.3. Now look at other indicators of creditworthiness, such as the company’s bond rating or the return on its stock. Are the different indicators providing consistent messages?
14.Use the Market Insight database (www.mhhe.com/edumarketinsight) to compare the average collection periods (see Section 29.3) for different companies. Can you explain why some companies grant more credit than others?
CHALLENGE QUESTIONS
1.Why do firms grant “free” credit? Would it be more efficient if all sales were for cash and late payers were charged interest?
2.Sometimes a firm sells its receivables at a discount to a wholly owned captive finance company. This captive finance company is partly financed by the parent, but it also issues substantial amounts of debt. What are the possible advantages of such an arrangement?
3.Reliant Umbrellas has been approached by Plumpton Variety Stores of Nevada. Plumpton has expressed interest in an initial purchase of 5,000 umbrellas at $10 each on Reliant’s standard terms of 2/30, net 60. Plumpton estimates that if the umbrellas prove popular with customers, its purchases could be in the region of 30,000 umbrellas a year. After deductions for variable costs, this account would add $47,000 per year to Reliant’s profits.
Reliant has been anxious for some time to break into the lucrative Nevada market, but its credit manager has some doubts about Plumpton. In the past five years, Plumpton had embarked on an aggressive program of store openings. In 2001, however, it went into reverse. The recession, combined with aggressive price competition, caused a cash shortage. Plumpton laid off employees, closed one store, and deferred store openings. The company’s Dun and Bradstreet rating is only fair, and a check with Plumpton’s other suppliers reveals that, although Plumpton traditionally took cash discounts, it has recently been paying 30 days slow. A check through Reliant’s bank indicates that Plumpton has unused credit lines of $350,000 but has entered into discussions with the banks for a renewal of a $1,500,000 term loan due at the end of the year. Table 32.1 summarizes Plumpton’s latest financial statements.
As credit manager of Reliant, how do you feel about extending credit to Plumpton?
4.Galenic, Inc., is a wholesaler for a range of pharmaceutical products. Before deducting any losses from bad debts, Galenic operates on a profit margin of 5 percent. For a long time the firm has employed a numerical credit scoring system based on a small number of key ratios. This has resulted in a bad debt ratio of 1 percent.
Galenic has recently commissioned a detailed statistical study of the payment record of its customers over the past eight years and, after considerable experimentation, has identified five variables that could form the basis of a new credit scoring system. On the evidence of the past eight years, Galenic calculates that for every 10,000 accounts it would have experienced the following default rates:
CHAPTER 32
Credit Management
925
Credit Score under
Number of Accounts
Proposed System
Defaulting
Paying
Total
Greater than 80
60
9,100
9,160
Less than 80
40
800
840
Total
100
9,900
10,000
By refusing credit to firms with a low credit score (less than 80), Galenic calculates that it would reduce its bad debt ratio to 60/9,160, or just under .7 percent. While this may not seem like a big deal, Galenic’s credit manager reasons that this is equivalent to a decrease of one-third in the bad debt ratio and would result in a significant improvement in the profit margin.
a.What is Galenic’s current profit margin, allowing for bad debts?
b.Assuming that the firm’s estimates of default rates are right, how would the new credit scoring system affect profits?
c.Why might you suspect that Galenic’s estimates of default rates will not be realized in practice? What are the likely consequences of overestimating the accuracy of such a credit scoring scheme?
d.Suppose that one of the variables in the proposed scoring system is whether the customer has an existing account with Galenic (new customers are more likely to default). How would this affect your assessment of the proposal?
2001
2000
2001
2000
T A B L E 3 2 . 1
Plumpton Variety
Cash
$ 1.0
$ 1.2
Payables
$ 2.3
$ 2.5
Stores: summary
Receivables
1.5
1.6
Short-term loans
3.9
1.9
financial statements
Inventory
10.9
11.6
Long-term debt
1.8
2.6
(figures in millions).
Fixed assets
5.1
4.3
Equity
10.5
11.7
Total assets
$18.5
$18.7
Total liabilities
$18.5
$18.7
2001
2000
Sales
$55.0
$59.0
Cost of goods sold
32.6
35.9
Selling, general, and administrative expenses
20.8
20.2
Interest
.5
.3
Tax
.5
1.3
Net income
$ .6
$ 1.3
PART NINE RELATED WEBSITES
For an introductory guide to understanding financial statements see:
www.ibm.com/investor/financialguide
For easy access to annual reports see:
www.reportgallery.com
www.prars.com
Downloadable software for shortand longterm financial planning is available on:
www.decisioneering.com
Journals with articles on short-term financial management include:
www.americanbanker.com
www.intltreasurer.com
www.treasuryandrisk.com
The Federal Reserve Bank sites are good general sources of reference for short-term interest rates and material on payment systems. See, for example:
www.federalreserve.gov
www.ny.frb.org
www.stls.frb.org
Sites on short-term debt markets include:
www.afponline.org (money market and interest rate data)
www.gecfosolutions.com (GE Capital’s website contains information on sources and costs of short-term finance)
www.ny.frb.org/pihome/addpub/credit. pdf (a guide to sources of credit)
The websites of most major banks provide material on cash management services. See, for example:
www.bankone.com
www.bankofamerica.com
Other sites dealing with cash management include:
www.nacha.org (material on electronic payment)
www.phoenixhecht.com (a comprehensive website on cash management with useful links)
Some sites that are concerned with credit management:
www.creditworthy.com (credit management)
www.dnb.com (examples of Dun and Bradstreet credit reports, articles on credit management, and an introductory guide to understanding financial statements)
www.ftc.gov/bcp/conline/pubs/credit/ scoring.htm (a guide to credit scoring)
www.nacm.org (contains links to sites on credit-related issues)
C H A P T E R T H I R T Y - T H R E E
M E R G E R S
928
THE SCALE AND pace of merger activity in the United States have been remarkable. In 2000, the peak of the merger boom, U.S. companies were involved in deals totaling more than $1.7 trillion. Table 33.1 lists just a few of the more important recent mergers, including several that involved overseas companies.
During these periods of intense merger activity, management spends significant amounts of time either searching for firms to acquire or worrying about whether some other firm will acquire their company.
A merger adds value only if the two companies are worth more together than apart. This chapter covers why two companies could be worth more together and how to get the merger deal done if they are. We proceed as follows.
•Motives. Sources of value added.
•Dubious motives. Don’t be tempted.
•Benefits and costs. It’s important to estimate them consistently.
•Mechanics. Legal, tax, and accounting issues.
•Takeover battles and tactics. We look back to several famous takeover battles. This history illustrates merger tactics and shows some of the economic forces driving merger activity.
•Mergers and the economy. How can we explain merger waves? Who gains and who loses as a re-
sult of mergers?
This chapter concentrates on ordinary mergers, that is, combinations of two established firms. We keep asking, What makes two firms worth more together than apart? We assume mergers are undertaken to cut costs, add revenues, or create growth opportunities.
But mergers also change control and ownership. Pick a merger, and you’ll almost always find that one firm is the protagonist and the other is the target. The top management of the target firm usually departs after the merger.
Financial economists now view mergers as part of a broader market for corporate control. The activity in this market goes far beyond ordinary mergers. It includes spin-offs and divestitures, where a company splits off part of its assets and operations into an independent corporation. It includes restructurings, where a company reshapes its capital structure to change incentives for managers. It includes buyouts of public companies by groups of private investors.
When corporate control changes, the first questions to ask are: Who owns the business now? Who is running it? How closely do the owners control the managers? What incentives do the managers now have?
Such questions take us well beyond the analysis of ordinary mergers. In this chapter we concentrate on mergers. In the next, we move on to the market for corporate control.
T A B L E 3 3 . 1
Acquiring Company
Selling Company
Payment ($ billions)
Some important
Vodafone Air Touch (UK)
Mannesmann (Ger)
202.8
mergers in 2000 and
America Online
Time Warner
106.0
2001.
Pfizer
Warner-Lambert
89.2
Source: Mergers and
Glaxo Wellcome (UK)
SmithKline Beecham (UK/US)
76.0
Acquisitions, various issues.
Bell Atlantic
GTE
53.4
Total Fina (Fr)
Elf Aquitaine (Fr)
50.1
AT&T
MediaOne
49.3
France Telecom (Fr)
Orange (UK)
46.0
Viacom
CBS
39.4
Chase Manhattan
J.P. Morgan
33.6
Citigroup
Associates First Capital
31.0
BP Amoco (UK)
Atlantic Richfield
27.2
929
930
PART X Mergers, Corporate Control, and Governance
33.1 SENSIBLE MOTIVES FOR MERGERS
Mergers that take place between two firms in the same line of business are known as horizontal mergers. Recent examples include bank mergers, such as Chemical Bank’s merger with Chase and Nationsbank’s purchase of BankAmerica. Other headline-grabbing horizontal mergers include those between oil giants Exxon and Mobil, and between British Petroleum (BP) and Amoco.
A vertical merger involves companies at different stages of production. The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer. An example is Walt Disney’s acquisition of the ABC television network. Disney planned to use the ABC network to show The Lion King and other recent movies to huge audiences.
A conglomerate merger involves companies in unrelated lines of businesses. The majority of mergers in the 1960s and 1970s were conglomerate. They became less popular in the 1980s. In fact, much of the action since the 1980s has come from breaking up the conglomerates that had been formed 10 to 20 years earlier.
With these distinctions in mind, we are about to consider motives for mergers, that is, reasons why two firms may be worth more together than apart. We proceed with some trepidation. The motives, though they often lead the way to real benefits, are sometimes just mirages that tempt unwary or overconfident managers into takeover disasters. This was the case for AT&T, which spent $7.5 billion to buy NCR. The aim was to shore up AT&T’s computer business and to “link people, organizations and their information into a seamless, global computer network.”1 It didn’t work. Even more embarrassing (on a smaller scale) was the acquisition of Apex One, a sporting apparel company, by Converse Inc. The purchase was made on May 18, 1995. Apex One was closed down on August 11, after Converse failed to produce new designs quickly enough to satisfy retailers. Converse lost an investment of over $40 million in 85 days.2
Many mergers that seem to make economic sense fail because managers cannot handle the complex task of integrating two firms with different production processes, accounting methods, and corporate cultures. This was one of the problems in the AT&T–NCR merger. It also bedeviled Novell’s acquisition of Wordperfect. That merger at first seemed a perfect fit between Novell’s strengths in networks for personal computers and Wordperfect’s applications software. But Wordperfect’s postacquisition sales were horrible, partly because of competition from other word processing systems but also because of a series of battles over turf and strategy:
Wordperfect executives came to view Novell executives as rude invaders of the corporate equivalent of Camelot. They repeatedly fought with . . . Novell’s staff over everything from expenses and management assignments to Christmas bonuses. [This led to] a strategic mistake: dismantling a Wordperfect sales team . . .
needed to push a long-awaited set of office software products.3
The value of most businesses depends on human assets—managers, skilled workers, scientists, and engineers. If these people are not happy in their new roles
1Robert E. Allen, AT&T chairman, quoted in J. J. Keller, “Disconnected Line: Why AT&T Takeover of NCR Hasn’t Been a Real Bell Ringer,” The Wall Street Journal, September 9, 1995, p. A1.
2Mark Maremount, “How Converse Got Its Laces All Tangled,” Business Week, September 4, 1995, p. 37.
3D. Clark, “Software Firm Fights to Remake Business after Ill-Fated Merger,” The Wall Street Journal, January 12, 1996, p. A1.
