Question

8. Campbell Computing Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days. The financial manager estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs are 80 percent of sales, and Campbell has a 15 percent receivables financing cost. (Assume there are 360 days a year.) 1. What would be the incremental cost of carrying receivables if this change were made? 2. What would be the incremental bad losses if the changes were made?

Answer 1

currently has sales of $1,000,000

days sales outstanding is 30 days

The financial manager estimates that offering longer credit terms would

(1) increase the days sales outstanding to 50 days

(2) increase sales to $1,200,000.

However, bad debt losses, which were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old sales would stay at 2 percent).

Variable costs are 80 percent of sales

Campbell has a 15 percent receivables financing cos

(Assume there are 360 days a year.)

1. What would be the incremental cost of carrying receivables if this change were made?

cost of carrying receivables is the opportunity cost of its best use

Formula

cost of carrying receivables = DSO x Sales per day x variable cost ratio x cost of receivables financing

Here,

DSO = Days sales outstanding  

Sales per day = total sales / 360

But here the question asked that calculate the incremental cost of carrying receivables. For this purpose we calculate carrying cost in each situation (before policy change and after policy change)

before policy change cost of carrying receivables =

Here,

DSO = Days sales outstanding  = 30 days

Sales per day = 1000000 / 360 = 2777.78

Variable cost ratio = 80% = 0.80

Cost of receivable financing = 15% = 0.15

Put the value to the above formula,

cost of carrying receivables = 30 * 2777.78 * 0.80 * 0.15 = $ 10000                

After policy change cost of carrying receivables =

DSO = Days sales outstanding  = 50 days

Sales per day = 1200000 / 360 = 3333.33

cost of carrying receivables = 50 * 3333.33 * 0.80 * 0.15 = $ 20000

Incremental cost of carrying receivables = After policy change cost of carrying receivables - before policy change cost of carrying receivables

Incremental cost of carrying receivables = $ 20000 - $ 10000 = $ 10000

$ 10000 are estimate to increased in cost of carrying receivables when the policy are change, because of the increase in days sales in outstanding. It leads to opportunity cost.

2. What would be the incremental bad losses if the changes were made?

For this calculation, first we calculate bad losses in each situation

before policy change Bad losses = 2 percent of sales

Bad losses = sales * 2%

         = 1000000 * 2% = 20000

After policy change Bad losses = 2 percent of old sales sales + 5% incremental sales

incremental sales = 1200000 - 1000000 = 200000

Bad losses = ( 1000000 * 2% ) + ( 200000 * 5% )

           = 20000 + 10000 = $ 30000

incremental bad losses = New bad losses - old bad losses

incremental bad losses = 30000 - 20000 = $ 10000

$ 10000 are estimate to increased in bad losses when the policy are change, because of increase in credit sales and increase in day sales outstanding