Question

ABC Corp is considering an ‘easing’ of credit policy to expand sales. The following data has been assembled:

Additional Sales: $1,000,000

Production/marketing Costs= 60% of Sales.

Collection Costs = 12% of Sales.

Bad Debts= 16% of sales.

Tax Rate = 10%

Accts Receivable turnover = 5

Inventory Turnover= 4

Cost of Capital= 15%

Q1:Project Net Income (after taxes) on additional sales.

Q2:What is the additional required investment in Inventory?

Q3 :What is the additional required investment in A/R?

Q4 :What is the return on the total additional investment?

Q5 :Should the company ease it’s credit policy?Justify response.

Answer 1

1.

Additional Sales	1,000,000
Production/marketing Costs	600,000	=60%*Sales
Collection Costs	120,000	=12%*Sales
Bad Debt Write Off	160,000	=16%*Sales
Profit Before Tax	120,000	= Sales - Costs
Tax	12,000	=10%*Profit Before Tax
Net Income	108,000	= Profit Before Tax- Tax

2. Inventory Turnover = 4 = CoGS/ Inventory = 60%*1000000/Inventory. So investment in Inventory = 600,000/4 = 150,000. Additional Investment in Inventory = 150,000

3. A/R Turnover = 5; since credit sales easing, hence all are credit sales.

A/R Turnover = Credit Sales / A/R. So A/R = Credit Sales / A/R Turnover = 1000000/5 = 200,000

So additional investment into A/R = 200,000

4. Total Additional Investment = 200,000 + 150,000 = 350,000

5. Now, with credit policy we need a return of 15% which means that with 350K investment, we need atleast 15%*350K amount = 52,500. And We are getting more than that in Net Income of 108,000.

Hence the company should ease it's credit policy