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

Calculation of cost of carrying the accounts receivable
Assuming 360 days in a year
If sales is $1,000,000
Cost of carrying receivables = Days sales outstanding*(Sales/360)*(Variable cost ratio)*Cost of funds
Cost of carrying receivables = 30*(1000000/360)*80%*15%	$10,000
Cost of carrying receivables = 50*(1200000/360)*80%*15%	$20,000
Increase in cost of carrying receivables	$10,000
Annual incremental after tax profit if credit period is extended
Incremental sales (1200000-1000000)	$200,000
Variable costs (200000*80%)	-$160,000
Contribution margin	$40,000
Incremental cost of carrying receivables	-$10,000
Bad debt expense - 200000*5%	-$10,000
Incremental before tax profit	$20,000
Tax @ 21%	$4,200
Annual incremental after tax profit	$15,800
Thus, the annual incremental after tax profit would be $15,800 if credit period is extended