Question

Puzzle Country, Inc. currently makes all sales on credit and offers no cash discount. The firm is considering a 3 percent cash discount for payment within 10 days. The firm's current average collection period is 90 days, sales are 2,500 puzzles per year, selling price is $20 per puzzle, variable cost per puzzle is $8,75, and the average cost per film is $10. The firm expects that the change in credit terms will result in a minor increase in sales of 100 puzzles per year, that 75 percent of the sales will take the discount, and the average collection period will drop to 30 days. The firm's bad debt expense is expected to become negligible under the proposed plan. The bad debt expense is currently 0.5 percent of sales. The firm's required return on equal-risk investments is 20 percent. (Assume a 360-day year.). Should this firm offer cash discount?

Answer 1

Solution

We will compare old/current scheme and proposed 3% discount scheme:

Current Net Profit
Sales (2500 * @20)	50,000
Cost of Sales
Variable Cost	21,875
(2500* $8.75)
Fixed Cost	3,125
(2500*$1.25)
Bad Debts Expense	250
($50,000 * 0.5%)
Interest cost on Debtors	2,500
(Average debtors * Interest rate)
(50000*(90/360)*20%
Total Cost	27,750
Profit	22,250

Proposed Net Profit
Sales (2600 * @20)	52,000
Cost of Sales
Variable Cost	22,750
(2600* $8.75)
Fixed Cost	3,125
(Fixed as above $3,125)
Bad Debts Expense	-
($52,000 * 0.0%)
Interest cost on Debtors	867
(Average debtors * Interest rate)
(52000*(30/360)*20%
Discount	1,170
(52000 * 75% * 3%)
Total Cost	27,912
Profit	24,088

Net saving (profit) in new scheme is higher than the old scheme so Form offer Cash Discount.