ADONGO'S STRATEGIC OPTION MODEL

ADONGO’S STRATEGIC OPTION MODEL

The topic I am much concern today is credit management. In credit management, when a firm sells goods and services there are strictly two factors to be considered; either it can be paid in cash immediately or wait for a time to be paid, that will extend credit to customers. These two factors set out two alternative credit strategies; either the company can offer credit or the company refuse credit. The decision to grant credit depends on four factors.

1)The delayed revenues from granting credit, (1+r_R)NPV/2H.

2)The immediate cost of granting credit, NPV/2.

3)The appropriate require rate of return for delayed cash flows, r_R

4)The probability of payment, H.

Granting credit produces delayed expected cash inflows equal to  H_*(1+r_R)_*NPV/2H. The cost is incurred immediately and requires number of discounting.  Adongo’s (or my) strategic Option Model is give as;

NPV=2HP_tQ_t/(1+r_R)

Or

NPV=2C_tQ_t

Where;

NPV=Net present value.

P_t=Price per unit received at time, t.

C_t=Cost per unit incurred at time, t.

Q_t=Quantity sold at time, t.

H=Probability of payment.

r_R=Rate of return for delayed cash flows.

When granting credit, a company tries to distinguish between customers that will pay and those will not pay. Obtaining a better estimate of the probability, H that a customer will default can lead to better decision. If the probability of payment of a customer is weak, the company would like to avoid to such deadbeat. If the company refuse credit, then the probability of payment should be H=1, so that the cost per unit is approximately equal to price per unit (i.e C_t≈P_t). Also, if the company offer credit, then the probability of payment should be H<1, so that C_t<P_t.

STRATEGY A:

Refuse credit. If the company refuses to grant credit, cash flows will be delayed and period or time 0 net cash flows, NCF, will be

NCF=2HP₀Q₀

Or

NCF=2C₀Q₀

STRATEGY B:

Offer credit. Alternatively, let us considered that, the company grants credit to all customers for one period. The influences of the decision are listed below.

	STRATEGY A(REFUSE CREDIT)	STRATEGY B(OFFER CREDIT)
PRICE PER UNIT	P0=150	P’0=200
QUANTITY PER UNIT	Q0=10	Q’0=10
COST PER UNIT	C0=150	C’0=150
PROBABILITY OF PAYMENT	H=1	H=0.76
CREDIT PERIOD	0 PERIOD	1PERIOD
RATE OF RETURN	rR=0	rR=0.01

REFERENCE

*Adongo Ayine William(Me), Diary(Or Weblog), “Adongo’s Mathematical Profile"