Credit Policy Decisions
Collins Office Supplies is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 5 percent of new sales; production and selling costs are 78 percent; and accounts receivable turnover is five times. Assume income taxes of 30 percent and an increase in sales of $80,000. No other asset buildup will be required to service the new accounts.
a.What is the level of accounts receivable to support this sales expansion?
Investment in Accounts Receivable:
b.What would be Collin's incremental after-tax return on investment?
Accounts Uncollectible( 7,200)* 9% of new sales
Annual Incremental Revenue$72,800
Collection Costs( 4,000)* 5% of new sales
Production & Selling Costs(62,400)*78% of new sales
Annual Income before taxes$ 6,400
Taxes (30%)( 1,920)
Incremental Income after taxes$ 4,480
Return on Incremental Investments:
c.Should Collins liberalize credit if a 15 percent after-tax return on investment is required?
Yes, the Return on Incremental Investment of 28% exceeds the require return of 15%
Assume that Collins also needs to increase its level of inventory to support new sales and that inventory turnover is four times.
d.What would be the total incremental investment in accounts receivable and inventory to support a $80,000 increase in sales?
Investment in Inventory:
Total Incremental Investment
Accounts Receivable 16,000
Return on Investment:
e.Given the income determined in part b and the investment determined in part d, should Collins extend more liberal credit terms?
No, the Return on Investment of 12.44% is less than the required return of 15%