Question

Global Services is considering a promotional campaign that will increase annual credit sales by $520,000. The company will require investments in accounts receivable, inventory, and plant and equipment. The turnover for each is as follows:  
  

Accounts receivable	4	times
Inventory	8	times
Plant and equipment	4	times

     
All $520,000 of the sales will be collectible. However, collection costs will be 3 percent of sales, and production and selling costs will be 72 percent of sales. The cost to carry inventory will be 8 percent of inventory. Depreciation expense on plant and equipment will be 5 percent of plant and equipment. The tax rate is 30 percent.

a. Compute the investments in accounts receivable, inventory, and plant and equipment based on the turnover ratios. Add the three together.
  

    

b. Compute the accounts receivable collection costs and production and selling costs and then add the two figures together.
  

   

c. Compute the costs of carrying inventory.
  

   

d. Compute the depreciation expense on new plant and equipment.
  

     

e. Compute the total of all costs from parts b through d.
  

   

f. Compute income after taxes.
  

   

g-1. What is the aftertax rate of return? (Input your answer as a percent rounded to 2 decimal places.)
  

    

g-2. If the firm has a required return on investment of 12 percent, should it undertake the promotional campaign described throughout this problem?
  

	Yes
	No

Answer 1

a)

Investments

Particulars	Amount
Accounts receivables	Sales / Accts receivable turnover = $520,000 / 4 = $130,000
Inventory	Sales / inventory turnover = $520,000 / 8 = $65,000
Plant and Equipement	Sales / P&E turnover = $520,000 / 4 = $130,000

b) Accounts receivable collections costs = 3% of sales = $520,000 x 3% = $15,600

Production and selling costs = 72% of sales = $520,000 x 72% = $374,400

Total = $15600 + $374400 = $390,000

c) Cost of carrying inventory = 8% of inventory = 8% x $65000 = $5200

d) Depreciation = 5% of plant and equipment = $130,000 x 5% = $6500

e) Total costs = $390,000 + $5200 + $6500 = $401,700

f) Income after taxes = (Sales - Total costs) x (1 - tax rate) = ($520,000 - $401,700) x (1 - 0.30) = $82,810

g-1) After tax rate of return = Income after taxes / Sales = $82,810 / $520,000 = 0.1593 or 15.93%

g-2) Yes, the investment should be undertaken since after tax return of 15.93% is greater than required return of 12%.