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 …show more content…
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 …show more content…
I believe they should liberalize credit because a 28% return is well enough over the required 15% return and anything extra, over and above the required 15% might assist in compensating for some of the uncollectible accounts.
Assume Collins also needs to increase its level of inventory to support new sales and that inventory turnover is four times.
17.d) What would be the total incremental investment in accounts receivable and inventory to support an $80,000 increase in sales?
The investment in inventory would be the new sales divided by the inventory turnover of four times ($80,000/4 = $20,000). The $20,000 investment minus accounts receivable on new sales ($16,000) is $36,000. Now, we divide incremental income ($4,480) into incremental investment ($36,000) for a 12.44% return on investment.
$80,000/4 = $20,000
Accounts receivable $16,000
Incremental investment $36,000
$4,480/$36,000 = 12.44% return on