Question

Accounts receivable changes without bad debts Tara’s Textiles currently has credit sales of $360 million per year and an average collection period of 60 days. Assume that the price of Tara’s products is $60 per unit and that the variable costs are $55 per unit. The firm is considering an accounts receivable change that will result in a 20% increase in sales and a 20% increase in the average col-lection period. No change in bad debts is expected. The firm’s equal-risk oppor-tunity cost on its investment in accounts receivable is 14%. (Note: Use a 365-day year.) a. Calculate the additional profit contribution from sales that the firm will realize if it makes the proposed change. b. What marginal investment in accounts receivable will result? c. Calculate the cost of the marginal investment in accounts receivable. d. Should the firm implement the proposed change? What other information would be helpful in your analysis?

Answer 1

a.
Sales quantity = 360/60	6	million units
Contribution margin = (Sales - Variable cost)*Number of units sold
Increase in sales quantity	6000000*20%	1,200,000
Contribution margin per unit = (60-55)		$5
Additional contribution		$6,000,000
The additional profit contribution from sale which the firm would realized from the proposed change is $6,000,000.
b.
Calculation of marginal investment in accounts receivable
Average investment in accounts receivable	Variable cost of annual sales/Accounts receivable turnover ratio
Accounts receivable turnover = Credit Sales/Accounts receivable
Accounts receivable turnover, present	360/60	6
Accounts receivable turnover, proposed	360/(60*1.20)	5
Marginal investment in accounts receivable
Average investment, current	(6000000*55)/6	$55,000,000
Average investment, proposed	(7200000*55)/5	$79,200,000
Marginal investment in accounts receivable		$24,200,000
c.
Cost of marginal investment in accounts receivable
Marginal investment in accounts receivable	$24,200,000
Required return	14%
Cost of marginal investment in accounts receivable	$3,388,000
d.
The additional contribution margin of $6,000,000 is more than the cost of marginal investment in accounts receivable of $3,388,000 and therefore the proposed change should be implemented
The other information that should be considered include bad debt estimates, any uncertainty in achieving the target sales and other manual costs.