Fin 200 Credit Policy Decisions

Topics: Balance sheet, Accounts receivable, Income Pages: 3 (598 words) Published: September 28, 2011
Credit Policy Decisions

Credit Policy Decisions
Foundations of Financial Management, Alternative Financing Plans, problem 17 (Block, B.B., Hirt, G.A., & Danielsen, B.R., 2009, pg. 220).

Collins Office Supplies

17. Collins Office Supplies is considering a more liberal credit policy to increase sales, but expects that 9 percent of 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.

17.a) What is the level of accounts receivable needed to support this sales expansion? The projected amount in new sales ($80,000) divided into the collection costs of 5% equals $16,000 of investment of accounts receivables.

$80,000/5 = $16,000 investment of accounts receivables

17.b) What would be Collin’s incremental aftertax return on investment?

The accounts uncollectible at 9% of new sales ($80,000) are $7,200. The new sales minus accounts uncollectible are $72,800, which is the annual incremental revenue. In order to get the annual earnings before taxes, we must subtract collection costs of 5% ($4,000) and subtract production and selling costs at 78% ($62,400) from the annual incremental revenue ($72,800), which gives us a total of $6,400 in annual earnings before taxes; subtract taxes at 30% ($1,920) and this gives us our incremental income after taxes. Now, we want to divide the incremental income after taxes into the investment of accounts receivables, which equals 0.28 or 28%. Therefore, the return on incremental investment is 28%.

New Sales$80,000
Accounts Uncollectible $7,200
Annual incremental revenue$72,800
Collection costs$4,000
Production and selling costs$62,400
Incremental income$4,480

$4,480/$16,000 = 0.28 or 28%...

References: Block, B.B., Hirt, G.A., & Danielsen, B.R. (2009). Foundations of financial management (13th ed.). New York, NY: McGraw Hill/Irwin.
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