Dome Metals has credit sales of $360,000 yearly with credit terms of net 45 days

Question

Dome Metals has credit sales of $360,000 yearly with credit terms of net 45 days, which is also the average collection period. Assume the firm adopts new credit terms of 5/10, net 45 and all customers pay on the last day of the discount period. Any reduction in accounts receivable will be used to reduce the firm's bank loan which costs 12 percent. The new credit terms will increase sales by 20% because the 5% discount will make the firm's price competitive.
   
a. If Dome earns 25 percent on sales before discounts, what will be the net change in income if the new credit terms are adopted? (Use a 360-day year.)
  

   

b. Should the firm offer the discount?
  

Explanation / Answer

Credit Sales $3,600,000 Credit term 45 days New Sales 3600000*1.20 4320000 Increase in profit from new sales Profit percent*Increase in sales 0.25(4320000-3600000) 180000 Average accounts receivable balance without discount Average collection period*Average daily sales (45*3600000/360) 450000 Average accounts receivable with discount (10*4320000/360) 120000 Reduction in accounts Receivable 450000-120000 330000 Interest savings 12%*330000 39600 Cost of discount Discount rate * Sales 0.05*4320000 216000 Net Gain/Loss Increase in Profit+ Interest savings - Cost of discount 180000+39600-216000 3600 Yes, the firm should offer the discount. This would give savings of $ 3600

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