4 Dagmar Bamberger, the president of Schwarzwald AG, has been exploring ways of improving the company’s financial performance. Schwarzwald manufactures and sells office equipment to retailers. The company’s growth has been relatively slow in recent years, but with an expansion in the economy it appears that sales may increase more quickly in the future. Dagmar has asked Johann Rüstow, the company’s treasurer, to examine Schwarzwald’s credit policy to see if a different credit policy can help increase profitability.

The company currently has a policy of net 30. As with any credit sales, default rates are always of concern. Because of Schwarzwald’s screening and collection process, the default rate on credit is currently only 1.5 per cent. Johann has examined the company’s credit policy in relation to other vendors, and he has determined that three options are available.

The first option is to relax the company’s decision on when to grant credit. The second option is to increase the credit period to net 45, and the third option is a combination of the relaxed credit policy and the extension of the credit period to net 45. On the positive side, each of the three policies under consideration would increase sales. However, the three policies have the drawbacks that default rates would increase, the administrative costs of managing the firm’s receivables would increase, and the receivables period would increase. The credit policy change would impact all four of these variables to different degrees. Johann has prepared the following table outlining the effect on each of these variables:

Mini Case 742 Annual Sales

(€ millions)

Default Rate

(% of Sales)

Administrative Costs (% of Sales)

Receivables Period (Days)

Current policy 120 1.5 2.1 38 Option 1 140 2.4 3.1 41 Option 2 137 1.7 2.3 51 Option 3 150 2.1 2.9 49 Schwarzwald’s variable costs of production are 45 per cent of sales, and the relevant interest rate is a 6 per cent effective annual rate. Which credit policy should the company use? Also, notice that in option 3 the default rate and administrative costs are below those in option 2. Is this plausible? Why, or