Question

You have been asked to assess the expected financial impact of each of the following proposals to improve the profitability of credit sales made by your company. Each proposal is independent of the other. Answer all questions. Showing your work may earn you partial credit.

Proposal #1 would extend trade credit to some customers that previously have been denied credit because they were considered poor risks.   Sales are projected to increase by $200,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 7% are projected to be uncollectible. Additional collection costs are projected to be 3% of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 80% of sales. Your firm expects to pay a total of 30% of its income after expenses in taxes.

1. Compute the incremental income after taxes that would result from these projections:

2. Compute the incremental Return on Sales if these new credit customers are accepted:

If the receivable turnover ratio is expected to be 4 to 1 and no other asset buildup is needed to serve the new customers…

3. Compute the additional investment in Accounts Receivable
4. Compute the incremental Return on New Investment

5. If your company requires a 20% Rate of Return on Investment for all proposals, do the numbers suggest that trade credit should be extended to these new customers? Explain.

Proposal #2 would establish local collection centers throughout the region to decrease the time it takes to convert credit payments that are mailed in by check to cash. It is estimated that establishing these collection centers would reduce the average collection time by 2 days.

1. If the company currently averages $60,000 in collections per day, how many dollars will this suggested cash management system free up?

2. If all freed up dollars would be used to pay down debt that has an interest rate of 5%, how much money could be saved each year in interest expense?

3. Do the numbers suggest that this new system should be implemented if its total annual cost is $5200? Explain.

Answer 1

Proposal #1

Incremental sales = $200,000

bad debts = 7% of $200,000 = $14,000

additional collection costs = 3% of $200,000 = $6,000

production and selling costs = 80% of $200,000 = $160,000

incremental income before tax = incremental sales - bad debts - additional collection costs - production and selling costs

incremental income before tax = $200,000 - $14,000 - $6,000 - $160,000 = $20,000

incremental income after tax = incremental income before tax * (1 - tax rate) = $20,000 * (1 - 30%) = $14,000

incremental return on sales = incremental income after tax / Incremental sales = $14,000 / $200,000 = 0.07, or 7%

receivable turnover ratio = sales / investment in accounts receivable

Additional investment in accounts receivable = incremental sales / receivable turnover ratio = $200,000 / 4 = $50,000

incremental return on new investment = incremental income after tax / Additional investment in accounts receivable

incremental return on new investment = $14,000 / $50,000 = 0.28, or 28%

If the company requires 20% return, the trade credit should be extended as the incremental return (28%) is higher than the required return

Proposal #2

dollars freed up = collections per day * reduction in collection time = $60,000 * 2 = $120,000

Saving in interest expense = interest rate * reduction in debt = 5% * $120,000 = $24,000

System should be implemented because saving in interest expense ($24,000) is higher than the annual cost ($5,200)