Question

You have been asked to assess the expected financial impact of each of the following proposals to improve the profitability of credit sales made by your company. Each proposal is independent of the other.

Proposal #2 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 $150,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 10% are projected to be uncollectible. Additional collection costs are projected to be 2% of incremental sales (whether they actually end up collected or not), 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.

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

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

If the receivable turnover ratio is expected to be 4 to 1 and no other asset buildup is needed to serve the new customers…

3. Compute the additional investment in Accounts Receivable

4. Compute the incremental Return on New Investment

5. 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.

Answer 1

1]	Incremental revenue	$   1,50,000
	Production and selling costs at 78%	$   1,17,000
	Bad debts = 150000*10% =	$       15,000
	Incremental collection costs = 150000*2% =	$         3,000
	Incremental income before taxes	$       15,000
	Tax at 30%	$         4,500
	Incremental income after taxes	$       10,500
2]	Incremental return on sales = 10500/150000 =	7.00%
3]	Additional accounts receivable = 150000/4 =	$       37,500
	Additional investment in accounts receivable = 37500*78% =	$       29,250
4]	Incremental return on new investment = 10500/29250 =	35.90%
5]	As the expected return on the new investment is more
	than the required return of 20%, credit can be extended
	to the new customers.