Question

Geoffrey’s Toy Box currently has sales of $1,000,000, and its days sales outstanding is 30 days. The new CFO estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2 percent on the old sales, would increase to 5 percent on the incremental sales while bad debts on the old sales would stay at 2 percent. Variable costs are 80 percent of sales, and Geoffrey’s Toy Box has a 15 percent receivables financing cost. Given corporate taxes of 21%, what would the annual incremental after-tax profit be if Geoffrey’s Toy Box extended its credit period?

Answer 1

Cost of carrying receivables = DSO*(Sales per day)*(Variable cost ratio)*(cost of funds)

Old sales: cost = 30*(1,000,000/360)*80%*15% = 10,000

New sales: cost = 50*(1,200,000/360)*80%*15% = 20,000

Formula		Current	Projected
	Sales (S)	1,000,000	1,200,000
80%*S	Variable costs (VC)	800,000	960,000
(S-VC)	Profit before credit cost (P)	200,000	240,000
	Cost of carrying receivables (CR)	10,000	20,000
Current: 2%*S Projected: (2%*Scurrent)+ 5%(Increase in sales)	Bad debt loss (D)	20,000	30,000
(P-CR-D)	Pre-tax profit	170,000	190,000
Pre-tax profit*(1-tax rate)	After-tax profit	134,300	150,100

Incremental after-tax profit = 150,100 - 134,300 = 15,800