Question

Proposal #1 would extend trade credit to some customers that previously have been denied credit because they were considered poor risks.   Sales are projected to increase by $150,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 7% are projected to be uncollectible. Additional collection costs are projected to be 3% of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 80% of sales. Your firm expects to pay a total of 40% of its income after expenses in taxes.

1)Compute the incremental income after taxes that would result from these projections:

2)Compute the incremental Return on Sales if these new credit customers are accepted:

If the receivable turnover ratio is expected to be 3 to 1 and no other asset buildup is needed to serve the new customers…

3)Compute the additional investment in Accounts Receivable

4)Compute the incremental Return on New Investment

5)If your company requires a 20% Rate of Return on Investment for all proposals, do the numbers suggest that trade credit should be extended to these new customers? Explain.

Answer 1

		A	Increase in sales	$150,000
		B=0.07*A	Amount expected to be Uncollectable	$10,500
		C=0.03*A	Additional collection cost	$4,500
		D=A-B-C	Net Increase in sales Revenue	$135,000
		E=0.8*A	Increase in production and selling cost	$120,000
		F=D-E	Increase in before tax income	$15,000
		G=0.4*F	Tax expense	$6,000
	1)	H=F-G	Incremental income after taxes	$9,000
	2)	I=H/A	IncrementalReturn on Sales	0.06
			IncrementalReturn on Sales(percentage)	6%
		J	Receivable turnover Ratio	3
			Receivable turnover Ratio=Sales/Accounts Receivable
	3)	K=A/J	Additional investment in Accounts receivable	$50,000
	4)	L=H/K	Incremental return on new investment	0.18
			Incremental return on new investment(Percentage)	18%
	5)		Trade should not be extended to these new customers
			Because return on investment is less than required return of 20%