Question

A company is thinking about changing its credit policy to attract customers away from competitors. The present policy calls for a 1.37/10, net 30 cash discount. The new policy would call for a 3.48/10, net 50 cash discount. Currently, 21% of its customers are taking the discount, and it is anticipated that this number would go up to 60% with the new discount policy. It is further anticipated that annual sales would increase from a level of $427k to $686k as a result of the change in the cash discount policy. The average inventory carried by the firm is based on an EOQ. Assume sales increase from 16k to 21.3k units. The ordering cost for each order is $200 and the carrying cost per unit is $1.82 – these values will not change with the discount. Each unit in inventory has an average cost of $11. Cost of goods sold equates to 69% of net sales, general and administrative expenses are 16% of net sales, and interest payments of 14% will only be necessary for the increase in the accounts receivable and inventory balances*(see information below). Taxes will be 36% of before-tax income. Note: The term “k” is used to represent thousands (× $1,000).

Required: Calculate the percentage in earnings after taxes (EAT) between the current policy (before the discount) and the new policy (after the discount).

Answer 1

Logan Distributing Company

Income Statement

Particulars	Existing Policy ($)	New Policy ($)
Net Sales ( Sales - Cash discount)	425712	667140
Cost of goods sold (69%of net sales)	293741	460327
Gross Profit	131971	206813
General and administrative expense (16% of net sales)	66114	106742
Operating Profit	65857	100071
Interest on increase in accounts receivable and inventory (14%)	5656	8320
Earnings before taxes	60201	91751
Taxes @ 36%	21672	33030
Earnings after taxes	38529	58721

Pecentage of increase in earnings after taxes between existing and new policy

Increase in Eearnings after taxes / Increase in average accounts receivables

= ( $58721 - $ 38529) / ($47528 - $30091)

= $20192/ $ 17437 = 11.5 %

Working Notes:

1. Computation of discount allowed

Existing Policy - $427000 * 21% * 1.37% = $1228.4

New Policy - $686000 * 79% * 3.48% = $18860

2. Computation of net credit sales

Existing Policy - $427000 - 1288 = $425712

New Policy - $686000 - 18860 =$ 667140

3. Accounts receivable = Average collection period * average daily sales

Existing Average collection period

0 .21 * 10 days = 2.1 days

0.79 * 30 days = 23.7 days

= 25.8 days ( Average accounts receivable)

New Average collection Period

0.60 * 10 days = 6 days

0.40 * 50 days = 20 days

= 26 days

average daily sales = Net credit sales/ 365

Existing - 425712 / 365 = $1166.3

New - 667140 / 365 = $1828

Average accounts receivable

Existing - 25.8 * 1166.3 =$ 30091

New - 26  * 1828 =$ 47528

4. EOQ =

=

=1875 units

New EOQ =

=

= 2164 units

Average Inventory Existing - EOQ/2 * $11

= (1875/2) * $11 = $ 10313

New - EOQ/2 * $ 11

= (2164/2) * $11 = $11902

5. Compuation of interest

Existing - ($ 30091 + $ 10313) * 14 % = $ 5656

New - ( $47528 + $11902) * 14% =$8320