Question

Proposal #1 would extend trade credit to some customers that previously have been denied credit because they were considered poor risks.   Sales are projected to increase by $200,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 6% are projected to be uncollectible. Additional collection costs are projected to be 5% of incremental sales, and production and selling costs are projected to be 78% of sales. Your firm expects to pay a total of 30% of its income after expenses in taxes.

A.)Compute the incremental income after taxes that would result from these projections:

B.) Compute the incremental Return on Sales if these new credit customers are accepted:

If the receivable turnover ratio is expected to be 5 to 1 and no other asset buildup is needed to serve the new customers…

C.) Compute the additional investment in Accounts Receivable

D.) Compute the incremental Return on New Investment

E.) If your company requires a 20% Rate of Return on Investment for all proposals, do the numbers suggest that trade credit should be extended to these new customers? Explain.

Proposal #2 would establish local collection centers throughout the region to decrease the time it takes to convert credit payments that are mailed in by check to cash. It is estimated that establishing these collection centers would reduce the average collection time by 2 days (from 5 days to 3 days).

A.) If the company currently averages $20,000 in collections per day, how many dollars will this suggested cash management system frees up?

B.) If all freed up dollars would be used to pay down debt that has an interest rate of 8%, how much money could be saved each year in interest expense?

C.) Do the numbers suggest that this new system should be implemented if its total annual cost is $5200? Explain.

Answer 1

Proposal 1

A.)Calculation of the incremental income after taxes that would result from these projections:

Sales	200,000
Less : Uncollectible (200,000 * 6%)	(12,000)
Less :Additional Collection Cost (200,000 * 5%)	(10,000)
Less :Production and Selling Cost (200,000 * 78%)	(156,000)
Income Before Taxes	22,000
Taxes @ 30% on 22,000	(6600)
Incremental Income After Taxes	15,400

(b) Calculation of incremental Return on Sales if these new credit customers are accepted :

Incremental Return = Incremental Income After Taxes / Incremental Sales

= 15400 / 200000

= 0.077 or 7.7%

(c.) Calculation of Additional Investment in New Receivables :

Additional Investment in New Receivables = 200000 / 5

= 40,000

(d.) Calculation of incremental Return on New Investment :

Incremental Return = Incremental Income After Taxes / Additional Investment in Receivables

= 15400 / 40000

= 0.385 or 38.5%

(e.) Yes , trade credit should be extended to these new customers as Incremental Return on New Investment is more than 20%.

Proposal 2

A) Dollars Freed up = Collection per day * Reduction in collection Time

= 20,000 * 2

= 40,000

B) Saving in Interest Expense = 40,000 * 8%

= 3200

C) No, the new system should note be implements since cost ($5200) is more than savings ($3200)