Multitech Limited

Multitech Limited, set up by a few technocrats in the mid 1990s, enjoyed a fairly healthy
growth rate till two years ago. Intense competition in the last few years has slowed down the
growth rate considerably.

The present sales of Multitech is Rs.800 million. In a recent executive committee meeting,
Jeevan Reddy, the marketing director, argued for relaxing the credit policy of Multitech to
stimulate sales increase. Gautam Singhvi, the finance director, promised to consider this
request favourably, provided the relation in credit policy had a positive impact on residual
income. The present credit policies of Multitech are as follows:

Credit Standards Multitech classifies customers into 4 categories, 1 through 4. Credit rating
diminishes as one goes from category 1 to category 4. Customers in category 1 have the
highest credit rating whereas customers in category 4 have the lowest credit rating. Currently
Multitech extends unlimited credit to customers in categories 1 and 2, limited credit to
customers in category 3, and no credit to customers in category 4.

Credit Period and Cash Discount Multitech provides 30 days of credit to its customers who
are deemed eligible for credit under its credit standards. Its credit terms are 1/10, net 30.

You have recently joined Multitech as a financial analyst and Gautam Singhvi has asked you
to examine the effect of relaxing credit standards, extending credit period, and providing
more generous cash discount. After talking to executives in the marketing, production and
finance departments, you have gathered the following information:
• Presently the proportion of credit sales and cash sales are 0.7 and 0.3. 50 percent of
the customers (by value) who are granted credit avail of the cash discount.
• The contribution margin ratio for Multitech is 20 percent, the tax rate for Multitech is
30 percent, the post-tax cost of capital for Multitech is 12 percent, and the average
collection period (ACP) on credit sales is 20 days.
• If the company extends unlimited credit to customers in category 3 and limited credit
to customers in category 4, the sales of the company would increase by Rs.50 million
on which the bad debt losses would be 12%. The ACP will remain unchanged at 20
days.
• If the company extends its credit period from 30 days to 60 days, its sales to
customers who are granted credit will increase by Rs.40 million. Further, the
percentage of customers who will avail of cash discount will decrease to 20 percent.
The ACP, as a result of the extension of the credit period, will increase to 50 days.
• If the company relaxes its discount terms to 2/10, net 30, its sales to customers who
are granted credit will increase by Rs.20 million. Further, the percentage of credit
customers who will avail of cash discount will increase to 70 percent and the ACP
will decrease to 16 days.
a. What will be the effect of relaxing the credit standards on residual income?
b. What will be the effect of extending the credit period on residual income?
c. What will be the effect of relaxing the cash discount policy on residual income?
Examine the impact of these credit policy changes one at a time.