Question

You have been asked to assess the expected financial impact of each of the following proposals to improve the profitability of credit sales made by your company. Each proposal is independent of the other. Answer all questions. Showing your work may earn you partial credit.

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, 10% are projected to be uncollectible. Additional collection costs are projected to be 2% of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 78% of sales. Your firm expects to pay a total of 30% 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 4 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.

Proposal #2 would establish local collection centers throughout the region to decrease the time it takes to convert credit payments that are mailed in by check to cash. It is estimated that establishing these collection centers would reduce the average collection time by 2 days.

1. If the company currently averages $40,000 in collections per day, how many dollars will this suggested cash management system free up?

2. If all freed up dollars would be used to pay down debt that has an interest rate of 6%, how much money could be saved each year in interest expense?

3. Do the numbers suggest that this new system should be implemented if its total annual cost is $5200? Explain.

Answer 1

Proposal 1

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

The value of incremental income after taxes is determined as below:

Sales Increase	150,000
Less Uncollectible (150,000*10%)	15,000
Incremental Revenue	135,000
Less Additional Collection Costs (135,000*2%)	2,700
Production and Selling Costs (150,000*78%)	117,000
Incremental Income before Taxes	15,300
Less Taxes	4,590
Incremental Income after Taxes	$10,710

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

The value of incremental return on sales is derived as follows:

Incremental Return on Sales = Incremental Income after Taxes/Sales*100 = 10,710/150,000*100 = 7.14%

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3) Compute the additional investment in Accounts Receivable:

The value of additional investment in accounts receivable is determined as below:

Additional Investment in Accounts Receivable = Sales/Accounts Receivable Turnover Ratio = 150,000/4 = $37,500

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4) Compute the incremental Return on New Investment:

The incremental return on new investment is calculated as follows:

Incremental Return on New Investment = Incremental Income after Taxes/Additional Investment in Accounts Receivable*100 = 10,710/37,500*100 = 28.56%

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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: Yes, the company should extend trade credit to customers because the incremental return on new investment (28.56%) is higher than the required rate of return on investment (20%).

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Proposal 2

1) If the company currently averages $40,000 in collections per day, how many dollars will this suggested cash management system free up?

Value of Dollars Freed Up = Average Collection Per Day*Reduction in Average Collection Time = 40,000*2 = $80,000

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2) If all freed up dollars would be used to pay down debt that has an interest rate of 6%, how much money could be saved each year in interest expense?

Savings in Interest Expense = Value of Dollars Freed Up*Interest Rate = 80,000*6% = $4,800

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3) Do the numbers suggest that this new system should be implemented if its total annual cost is $5200? Explain.

Answer: No, the new system should not be implemented because savings in interest expense ($4,800) resulting from this system is less than the total annual costs ($5,200) associated with the system.