Question

ROK currently makes all sales on credit and offers no cash discount. The firm is considering a 3 percent cash discount for payment within 15 days. Its current average collection period is 50 days, sales are 2000 films per year, selling price is $45 per film and the variable cost is $35 per film. ROK expects that the change in credit terms will result in an increase in sales to 2,200 films, of which 70 percent of sales will take the discount. Then the average collection period will drop to 30 days. The firms bad debts expense is expected to become negligible under the proposed plan. Its required return on equal-risk investments is 15%.

a.) What is the firms additional or marginal profit contribution from sales under the proposed plan of initiating the cash discount?

b.) What is the additional investment in accounts receivable with the proposed change?

c.) What is the cost (-) or benefits (+) of additional investments in ARs under the proposed plan?

d.) what is the total cost of offering the cash discount?

Answer 1

Answer (a):

Increase in sales in units per year = 2200 - 2000 = 200 units

Contribution per unit = Sales price - variable cost per unit = $45 - $35 = $10 per unit

Additional or marginal profit contribution from sales under the proposed plan = Increase in sales * Contribution per unit

= 200 * $10

= $2,000

Additional or marginal profit contribution from sales under the proposed plan = $2,000

Answer (b):

Existing investment in accounts receivable:

Given:

All sales are on credit and current average collection period is 50 days

Existing investment in accounts receivable = Annual sale value * collection period / 365

= (2000 * 45) * 50/365

= $12,328.76

Investment in accounts receivable with the proposed change:

Investment in accounts receivable with the proposed change = 2200 * 45 * 30/365

= $8,136.98

As such:

Additional investment in accounts receivable with the proposed change = 8136.98 - 12328.76 = - $4191.78

As such there is no additional investments but it will result in reduction in investment or release of investment to the extent of $4191.78

Answer (c)

Cost (-) of additional investments in ARs under the proposed plan:

Given that 70 percent of sales will take the discount

Cash Discount = 3%

Discount paid = 2200 * 45 * 70% * 3% = $2079

Benefits (+) of additional investments in ARs under the proposed plan:

(i) Additional or marginal profit contribution from sales under the proposed plan

As calculated in answer (a) above:

Additional or marginal profit contribution from sales under the proposed plan = $2,000

(ii)

As calculated in answer (b) above:

Reduction in investment or release of investment in account receivable = $4191.78

Benefit in terms of capital cost = 4191.78 * 15% = $628.77

As such net benefit = Benefits - Costs = 2000 + 628.77 - $2079 = $549.77

Answer (d):

As calculated in answer c above:

Cost of offering the cash discount = $2079