The Opportunity Cost of Capital and Credit Related Funds System
Chapter Six explained how the terms of sale offered by a creditor firm to its customers represent a potent aspect of its financial and marketing strategies. The availability of either a credit period, or a cash discount for prompt payment, provides its clientele with an effective reduction in the cash price for goods sold determined by their annual opportunity cost of capital. So, if price is inversely related to demand, the availability of trade credit can increase turnover.
Because individual customer opportunity cost of capital rates (r) determine the creditor firm's overall effective price-demand function, the purpose of this Chapter is to outline how management can assign values to (r) before choosing their best combination of credit period and cash discount variables designed to maximise profit.
The Opportunity Cost of Capital Rate
Conceptually (r) is the annual cost of employing a value unit of capital in one use rather than another. We defined it earlier as the rate at which a buyer can raise funds from alternative sources, to finance their purchases. Theoretically, this rate should be determined for each customer trading with a creditor firm, subject to the benefits exceeding costs (i.e. the profit from sales should exceed the costs of analysis).
In practice, however, this exercise is unlikely to be undertaken if the firm deals with a multiplicity of customers. A shortage of published data and their shortcomings also makes it difficult, even if average cost of capital rates are estimated as a proxy for customer's marginal opportunity rates at the time of sale, which are clearly more appropriate.
It is not sufficient to calculate customer opportunity rates using historic earnings per share (EPS), dividends paid to shareholders and actual interest on borrowings revealed by their financial accounts, or even their corresponding current yields in the financial press. Debtor firms also finance their operations by obtaining funds from a variety of sources at an implicit or opportunity cost, rather than any explicit cost. By definition, these should be included in the overall cost of capital calculation because they relate to funds which firms have at their disposal in order to generate output. Such items include retained earnings, trade credit granted by suppliers, as well as any delay in corporate tax payments, without which, firms would presumably have to raise finance elsewhere. In addition, there are implicit costs associated with depreciation and other non-cash expenses. These too, represent funds retained in a business, which are available for reinvestment.
For most creditor firms, the calculation of any customer's opportunity cost of capital rate (r) is formidable. Especially, if we consider that the fund proportions obtained from various sources are typically a combination of policy, convention and historical accident, which will differ from customer to customer and constantly change over time.
However the problem is not insoluble. It can be overcome by determining a range of assumed values for (r) from which one rate, premised on market intelligence and financial analysis is considered more appropriate for a particular buyer, or even class of buyers.
One definition of (r) that readily springs to mind is the minimum rate at which firms can borrow. This is commonly the rate charged on bank advances which, of course, varies over time. The justification for setting the minimum value at this low level is twofold.
- Firms can often borrow at rates close to this figure but rarely below it.
- In the absence of risk, rational management seeking to maximise money profits should employ capital if its marginal yield is at least equal to its minimum borrowing rate.
We can derive higher values of (r) from the interest rates at which firms can obtain funds from other sources such as the capital market, factoring organizations and so on. Alternatively, we can undertake the calculation of (r) by reference to industrial rates of return, either across all industry or preferably within the customer's own industry, both of which are distributed around the mean.
At the other end of the scale, since we are concerned with opportunity rates, an upper limit would be correctly estimated by the highest sectoral operating profit that can be earned on total assets (ROCE) irrespective of their use. However, this would represent an occasional surrogate only. What creditor firms require is a range of assumed values for (r), which is both readily available and of general applicability. Very high rates of return are the exception rather than the rule, occurring only under conditions of disequilibrium, or where there are peculiar social or institutional constraints on the mobility of capital.
Naturally, this range of opportunity rates would require periodic revision in the light of changing economic conditions, such as an increase in the minimum lending rate determined by government or Central Banks. Quite apart from this, the creditor firm would also have to estimate shifts in specific buyer opportunity rates. To ignore any of these capital cost movements would be tantamount to accepting the effective price-demand function for its products or services as a constant, which defeats the whole object of the exercise and may be sub-optimal.