Lewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a...

Lewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a result of the proposed relaxation, sales are expected to increase by 20%from14,000to16,800units during the coming year; the average collection period is expected to increase from30 to45days; and bad debts are expected to increase from2.5%to4.5%of sales. The sale price per unit is$ 38and the variable cost per unit is $ 26The firm's required return on equal-risk investments is 24.5%

Evaluate the proposed relaxation, and make a recommendation to the firm.

(Note:Assume a 365-day year.)

The additional profit contribution from an increase in sales is

Expert Solution

	Current	Proposed
	Plan	Plan
Sales revenue	532000	638400
(-) Variable cost	364000	436800
Contribution	168000	201600
(-) Bad debt expenses	13300	28728
Profit	154700	172872

Sales and variable cost are calculated by mutiplying with respective Units i.e 14000 * 38 and 14000 * 26 for current plan and 16800 * 38, 16800 * 26 for proposed plan.

The additional profit contribution from an increase in sales = 172872 - 154700	18172
(-) Required return on Increased Investment	5864
Excess of actual return over required return	12308

As seen from above calculations, it is recommended that company should relax the credit standards. Increase in profit due to relaxation is more than the required rate of return.

Working

Required return on increased investment is calculated as under

Required return on increased Investment
Current Plan = 14000 * 26 * 30/365	29917.81
Proposed plan = 16800 * 26 * 45/365	53852.05
Increase in Investment = (proposed - current)	23934.25
Required return on increased Investment @ 24.5%	5863.89

jeff jeffy answered 2 years ago

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