Question

Gardner Company currently makes all sales on credit and offers no cash discount. The firm is considering offering a 2% cash discount for payment within 15 days. The firm’s current average collection period is 60 days, sales are 40,000 units, selling price is $45 per unit, and variable cost per unit is $36. The firm expects that the change in credit terms will result in an increase in sales to 42,000 units, that 70% of the sales will take the discount, and that the average collection period will fall to 30 days. If the firm’s required rate of return on equal-risk investments is 25%, should the proposed discount be offered? (Note: Assume a 360-day year.)

Answer 1

2% cash discount for payment within 15 days

The firm’s current average collection period is 60 days

Particulars	Units	Per Unit	Amount	Revised Sales	Revised Amount
Sales	40000	$          45	$     1,800,000	42000	$        1,890,000
Variable Cost	40000	$          36	$     1,440,000	42000	$        1,512,000
Contribution-	-	$         360,000	-	$            378,000

Average Collection Period = 60 Days

On revising Credit Terms, Average Collection Period = 30 Days

I	Interest foregone on Account of Credit Allowed = $1,800,000 * 25% * (60/360)
	Interest foregone on Account of Credit Allowed = $75,000
II	Revised Scenario:
A	Increase of Profit on account of Increase in Sales = ($378,000 - $360,000)
	Increase of Profit on account of Increase in Sales = $18,000
B	Discount allowed on account of payment with in 15 days = ($1,890,000 * 70%) * 2%
	Discount allowed on account of payment with in 15 days = $26,460
C	Interest foregone on Account of Credit Allowed = $1,890,000 * 25% * (30/360)
	Interest foregone on Account of Credit Allowed = $39,375
D	Total Cost Under revised Credit Terms:
	(B + C) - A = ($26,460 + $39,375) - $18,000
E	Net Cost Under revised Credit Terms = $47,835
III	Net Benefit on account of revised Credit Terms = I - II
	Net Benefit on account of revised Credit Terms = $75,000 - $47,835
	Net Benefit on account of revised Credit Terms = $27,165

As there is net benefit on account of allowing Credit, It is advisable to offer proposed discount.