Academic journal article Financial Management

A Contingent Claims Analysis of Trade Credit

Academic journal article Financial Management

A Contingent Claims Analysis of Trade Credit

Article excerpt

Paul D. Adams is an Assistant Professor of Finance, Steve B. Wyatt is an Associate Professor of Finance, and Yong H. Kim is a Professor of Finance, all at the University of Cincinnati, Cincinnati, Ohio.

Trade credit involves the exchange of goods for a promised payment in some future period and accounts receivable represent a major proportion of corporate assets. However, little attention has been paid by the academic profession, as compared with other financial decisions, to the valuation of trade credit, i.e., the decision to grant credit and set credit limits. Furthermore, much of the limited literature has examined the credit decision from the perspective of the selling firm, without regard to financial market equilibrium or product market equilibrium.

Since trade credit involves a simultaneous transaction in both financial and product markets, it is important to make clear the assumption we are making about these markets when evaluating trade credit. If we assume that financial markets are competitive and complete, then all financial transactions are zero NPV in equilibrium, including the decision to grant trade credit. Firms cannot earn economic rents from simply granting trade credit.

With competitive and complete capital markets, the problem facing the firm that decides to offer trade credit is to grant credit to all firms whose discounted risky promise (DRP) is equal to (or greater than) the marginal cost (C) of goods sold on credit. If we further assume that the industry of the credit-granting firms is also perfectly competitive, then in equilibrium, the cash price for each firm's product equals the marginal cost of production. Since the cash price (|P.sup.*~) of goods is also equal to C, as in any competitive market, DRP = C = |P.sup.*~ in equilibrium. With competitive capital markets and competitive product markets, firm's product sales and trade credit extensions are zero NPV transactions.

If the product market is not perfectly competitive, then the product's cash price will be above marginal cost. Hence, firms can earn economic rents in the product market. For example, in the monopoly case, the optimal price |P.sup.*~ is greater than the marginal cost from a sale, hence |P.sup.*~ |is greater than~ C. Therefore, it is possible for the NPV of the credit sale to be positive when compared to C, just as the NPV of a cash sale would be positive as compared to C. This, however, does not imply that the NPV of the credit decision (the granting of credit) is a positive NPV decision because the marginal cost of a sale is not the correct comparison variable for determining the NPV of a credit decision. For the NPV of a credit decision to be positive, the seller must be in a position to earn economic rents from credit extension. The firm offering trade credit should not accept a credit sale over a cash sale unless the present value of the promised payment is at least as great as the cash sale |P.sup.*~ (i.e., DRP |is greater than or equal to~ |P.sup.*~). In this paper, we assume that the firm has some market power in the product market, but no market power in financial markets. This market power may be exploited in setting cash sale terms and credit sale terms that result in price discrimination. If this is the case, buyers may not be indifferent to cash versus credit purchases. If a credit policy can be used as such a tool, then granting credit may appear to be a positive NPV decision as compared to the cash price. Because antitrust considerations preclude outright price discrimination, the credit price performs this function. The correct comparison price for determining the NPV of the credit sale is not the current cash price, but the cash price that would be charged if price discrimination were allowed. Relative to this price, the NPV of the credit-granting decision must be zero. In this paper, we will take the optimal pricing decision as given.

The paper is organized as follows. Section I provides a brief review of the trade credit limit literature and motivates the current study. …

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