Question

Adjaye Ltd has current sales of GH¢1.5m per year. Cost of sales is 75 per cent of sales and bad debts are one per cent of sales. Cost of sales comprises 80 per cent variable costs and 20 per cent fixed costs, while the company’s required rate of return is 12 per cent. Adjaye Ltd currently allows customers 30 days credit, but is considering increasing this to 60 days credit in order to increase sales. It has been estimated that this change in policy will increase sales by 15 per cent and bad debts will increase from one per cent to four per cent. It is not expected that the policy change will result in an increase in fixed costs and creditors and stock will be unchanged. Required: Advice whether Adjaye Ltd should introduce the proposed policy. Support your answer with relevant computations.

Answer 1

		Current Policy	Proposed Policy
1)	Sales	$   15,00,000	$17,25,000
	Contribution margin at (75%*80%=60%)	$      9,00,000	$10,35,000
	Increase in contribution margin [1]			$      1,35,000
2)	Receivables:
	= 1500000*30/365 =	$      1,23,288
	= 1725000*60/365 =		$   2,83,562
	Investment in receivables at 60%	$         73,973	$   1,70,137
	Increase in investment		$      96,164
	Interest cost on increase in investment at 12% [2]			$         11,540
3)	Bad debts	$         15,000	$      69,000
	Increase in bad debts [3]			$         54,000
4)	Incremental pretax income = [1]-[2]-[3]			$         69,460
5)	The firm should introduce the proposed policy as it would result in incremental pretax income of
	$69,460.