expected payoff seems sensible, because as the credit quality of the receivable increases as a increases, the expected payoff converges to L the face value regardless of how
much credit monitoring is done by the seller or the factor. Also, if zero credit monitoring is performed by both the seller and the factor c 5 0 and m 5 0, then the expected payoff
will be bounded below by L1 2 1a. However, as the level of the seller’s or the factor’s credit monitoring effort increases, then the expected payoff on the receivable converges
at the rate b or d, respectively, to the promised payment, L.
10
Also, as c [ [0, ` and m [ [0, `, it is necessary to constrain the parameters such that Lb . u and Ld . w.
The Generalized Form of the Seller’s Expected Profit Function
The general form of the seller’s expected profit function is: e
2r
i
t
E
L
~1 2 b px 2 zbp~L 2 x dF ~ x ua, c, m 2 e
2r
i
t
upc 2 1
1 e
2r
t
t
b
H
E
L
x 1 zp~L 2 x dF ~ x ua, c, m 2 wm
J
, 1
where the first term is the seller’s expected payoff from keeping a fraction 1 2 b of the receivable minus the seller’s expected liability due to the recourse guarantee; the second
term is the seller’s monitoring cost; the third term is the initial investment; and the last term is the price that is paid to the seller by the factor.
III. The Seller’s Decision To Keep Its Accounts Receivable
When the seller keeps its accounts receivable, then b in equation 1 is identically equal to zero. In this case, the seller’s task is to choose a level of credit monitoring such that the
present value of its expected profit from keeping the receivable is maximized. By substituting b 5 0 into equation 1, the seller’s problem becomes:
Max
c.
e
2r
i
t
p
F
E
L
xdF ~ x ua, c 2 uc
G
2 1.
2 The first order condition is:
E
L
xdF
c
~ x ua, c 5 u.
3 Using the specific functional form for
L
x dF x
ua, c, the first order condition can be rewritten as:
10
The monitoring efficacy parameter, b, is a measure of the marginal increase in the receivable’s expected return from additional credit monitoring.
The Economics of Factoring Accounts Receivable 343
Lbe
2bc
a 5 u
, 4
and the seller’s equilibrium level of monitoring, c
k
, can be solved for explicitly c
k
5 Max
F
1 b
ln Lb
ua , 0
G
. 5
IV. The Seller’s Decision To Factor Its Accounts Receivable
This section focuses on modeling the optimal contract between the seller and a factor. Because factoring contracts usually involve the sale of the entire receivable, b will be
identically equal to 1. The model will demonstrate that, similar to Stiglitz and Weiss 1981, the existence of a moral hazard problem on the part of the seller plays an active
role in causing lower quality receivables to remain unsold or to be sold with recourse.
The Seller’s Decision to Factor the Receivable Without Recourse
If the seller factors its receivable without recourse, then b is equal to 1 and z is equal to 0. Because the seller’s level of credit monitoring is unobservable to the factor, a moral
hazard problem can develop.
Lemma 1.
If the seller’s level of credit monitoring is unobservable to the factor, then the seller will monitor at a level c 5
0.
11
Proof: See the Appendix. Intuitively, it is easy to see that in equilibrium, the seller’s level of credit monitoring
will be zero. Once the entire receivable is sold, the seller no longer bears the consequences of inefficient monitoring. Because the factor cannot ex-post verify the seller’s level of
credit management effort, once the seller receives the contracted payment from the factor, it will not derive any marginal benefit from further credit monitoring. A rational factor
will expect the zero level of monitoring by the seller and will, consequently, offer a price which reflects this knowledge. Thus the seller’s expected profit when it factors its
receivable without recourse will be:
e
2r
f
t
F
E
L
xdF ~ x ua, 0, m 2 wm
G
2 1.
6 In the above analysis, the factor pays the seller at time zero and will select a level of
credit management, ma, such that it solves Max
m L
x dF x
ua, 0, m 2 wm.
11
It is important to note that Lemma 1 depends crucially upon the model’s assumption of a one-period, no-reputation contract. As noted in John and Nachman 1985, the moral hazard problem may be partially
mitigated in multiperiod models which include a reputation feature.
344 B. J. Sopranzetti
Proposition 1.
If e
2r
i
t
p
F
L
S
1 2 u
Lb
D
2 u
b ln
Lb u
G
2 e
2r
f
t
F
L
S
1 2 w
Ld
D
2 w
d ln
Ld w
G
w d
e
2r
f
t
2 up
b e
2r
i
t
, 0,
then the seller will factor all of its accounts receivable without recourse .
Proof: See the Appendix. The inequality in Proposition 1 is derived by comparing the seller’s profit when it
factors a given receivable without recourse to its profit when it keeps the receivable. When the parameterization is such that the inequality is satisfied, then for any given value of
receivable credit quality, a, the seller’s profit will be greater when it factors the account receivable than when it keeps the receivable. Thus the seller will prefer to factor all of its
accounts receivable regardless of their credit quality.
Proposition 1 demonstrates that one possible motivation why firms choose to factor their accounts receivable may be to take advantage of the factor’s superior information
technology. This reason was suggested by Mian and Smith 1992 and empirically tested by Smith and Schnucker 1994. According to these two studies, firms which do not have
a customer specific sunk cost in information will have a higher propensity to factor their accounts receivable. The intuition behind Proposition 1 is that if the factor’s information
advantage is sufficiently large—in terms of the model’s parameters, if w is much smaller than u andor if d is much larger than b—then the price impact of the moral hazard
problem on the seller’s decision to factor its accounts receivable will be negligible. Consequently, if the inequality is satisfied, then the seller’s profit will always be higher
when it sells all of its accounts receivable and transfers the responsibility and the credit risk of monitoring the receivables to the factor, rather than retaining the receivables and
credit monitoring itself.
Now, assume that the inequality is not satisfied. Then for some value of a, the seller’s expected profit from factoring its receivables must equal the expected profit from keeping
the receivables.
12
Let a
n
be the receivable quality level such that e
2r
f
t
F
E
L
xdF ~ x ua
n
, c 5 0, m 2 wm
G
2 1 5 e
2r
i
t
p
F
E
L
xdF ~ x ua
n
, c
n k
, m 5 0
2 uc
n k
G
2 1.
7 Note that the left hand side is the expected equilibrium payoff to the seller from factoring
the receivable, and the right hand side is the expected equilibrium payoff from keeping the receivable.
12
In other words, the two expected profit functions must intersect for some value of a. The existence and uniqueness of the intersection point will be demonstrated in the proof of Proposition 2.
The Economics of Factoring Accounts Receivable 345
Proposition 2. If the inequality in Proposition 1 is not satisfied, then there exists a unique level of receivable credit quality, a
n
, such that for a . a
n
the seller will factor the receivable without recourse and perform zero credit monitoring, and for a a
n
the seller will keep the receivable and credit monitor at a level c 5 c
k
. Proof: See the Appendix.
The impact of the moral hazard problem on the price will be least severe for high credit quality receivables, as their expected payoffs will not depend greatly on the seller’s
monitoring efforts. On the other hand, the moral hazard problem will have a larger deleterious impact on the expected payoff to the intermediate and poor quality receivables;
consequently, the lower price offered for these receivables will be insufficient to motivate the seller to sell. Thus, in equilibrium, the seller will keep its intermediate and poor credit
quality receivables. Proposition 3. The breakpoint level of receivable credit quality such that the receivable
will be factored without recourse, a
n
, will be: decreasing in the seller’s cost of internal funding, r
i
; increasing in the factor’s cost of funding, r
f
; increasing in the seller’s monitoring efficacy parameter, b; decreasing in the factor’s monitoring efficacy param-
eter, d; and increasing in the factor’s cost of monitoring, w .
Proof: The proof consists of taking the derivative of a
n
with respect to r
i
, r
f
, b, d, and w. It is straightforward to demonstrate that the derivatives of a
n
with respect to r
f
, b, and w are greater than zero, while the derivatives with respect to r
i
and d are less than zero. As the seller’s cost of internal financing, r
i
, increases decreases relative to the factor’s financing cost, r
f
, the seller will find it relatively more less expensive to internally finance its trade credit. Sopranzetti 1997a argued that one of the possible motivations for
why a seller might choose to sell its accounts receivable is that the factor may be able to more cheaply fund the trade credit if its cost of internal funding is less than the seller’s cost
of internal funding. If this is true, then one would expect the comparative static result reported in Proposition 3: as the seller’s internal cost of capital increases decreases
relative to that of the factor, then the firm’s propensity to factor its accounts receivable would also increase decrease and, consequently, a
n
would decrease increase. As the firm’s monitoring efficacy parameter, b, increases decreases relative to the
factor’s efficacy parameter, d, the firm will have a lesser greater incentive to factor its accounts receivable, consequently, a
n
will increase decrease. This result is consistent with the findings of Smith and Schnucker 1994 who empirically demonstrated that firms
have a greater tendency to internalize the credit management function and hence to not factor their accounts receivable when they have a specific sunk investment in the
customersvendor relationship—such firms would have a larger relative spread between b and d.
As the factor’s cost of monitoring, w, increases, the committed level of monitoring by the factor will decrease and with it the equilibrium price which will be offered for the
receivable. The result will be a decrease in the proportion of the seller’s receivable pool that will be sold, i.e., an increase in a
n
.
13
Q.E.D.
13
Unfortunately, the comparative static result with respect to the seller’s cost of monitoring, u, on the break-point level of receivable credit-quality an, is ambiguous: the derivative a
n
du cannot be signed.
346 B. J. Sopranzetti
The Seller’s Decision to Factor the Receivable With Recourse
In this section, the seller is permitted to offer recourse if it wishes to do so; thus, in the event that the receivable’s actual payoff is less than its face value, the seller must
reimburse the factor for the delinquent amount. The value of this recourse guarantee is contingent upon the seller’s solvency at the end of the period. As the seller is made
contingently liable when the receivables are sold with recourse and, thus, bears some of the credit risk, it is reasonable to expect that the seller will choose some positive level of
credit monitoring in equilibrium.
Substituting b 5 1 and z 5 1 into equation 1 yields the seller’s profit function when it factors with recourse. Thus the seller’s equilibrium level of credit monitoring, c
r
, will solve:
Max
c
e
2r
f
t
E
L
xdF ~ x ua, c, m 1 e
2r
f
t
E
L
p~L 2 x dF ~ x ua, c, m 2 e
2r
i
t
upc
2 e
2r
i
t
E
L
p~L 2 x dF ~ x ua, c, m 2 e
2r
f
t
wm 2 1.
8 Equation 8 can be rewritten as:
Max
c
e
2r
f
t
E
L
xdF ~ x ua, c, m 1 ~e
2r
f
t
2 e
2r
i
t
E
L
p~L 2 x dF ~ x ua, c, m
2 upce
2r
i
t
2 e
2r
f
t
wm 2 1.
9 The first order condition is:
e
r
i
t
FS
1 p
2 1
D
e
2r
f
t
1 e
2r
i
t
G
E
L
xdF
c
~ x ua, c
r
, m 5 u. 10
Proposition 4. There exist a value, p, and levels of receivable credit quality, a
keep
and a
recourse
, such that when the seller’s probability of solvency p is less than p, the seller will keep receivables for which a , a
keep
, sell with recourse receivables for which a
keep
a , a
recourse
, and sell without recourse receivables for which a a
recourse
. Proof: See Appendix.
Corollary to Proposition 4. When p p , then the seller will sell with recourse
receivables for which a , a
recourse
, and sell without recourse receivables for which a a
recourse
. Proof: See the Appendix.
The implications of Proposition 4 and its corollary are very interesting. Because of the moral hazard problem inherent when the seller sells its accounts receivable, only the
highest quality receivables will be factored without recourse. For receivables the credit quality of which is above a
recourse
i.e., the highest quality receivables, the seller’s expected profit will be maximized when it sells them without recourse, because for these
receivables the price impact of the moral hazard problem is not very significant. The credit quality of these receivables is excellent, so even if the seller were to perform zero credit
The Economics of Factoring Accounts Receivable 347
management, there would still be a high probability that the factor would collect the receivable’s full face value at the maturity date.
Because of the larger impact of the moral hazard problem on the expected payoff to the intermediate and poor quality receivables, sellers must offer recourse in order to sell them.
As is delineated in the corollary to Proposition 4, sellers which have a high likelihood of being able to satisfy their recourse guarantee i.e., sellers with p p will be able to sell
all of their intermediate and poor quality accounts receivable through the use of recourse.
On the other hand, Proposition 4 demonstrates that sellers who have a low probability of being able to satisfy their recourse guarantee i.e., sellers with p , p will factor their
intermediate credit quality receivables with recourse, but will keep their poor quality receivables because the equilibrium price offered by the factor for these receivables will
be too low to motivate the sellers to sell.
V. Data and Empirical Methodology
