Dome Metals has credit sales of $342,000 yearly with credit terms of net 45 days

Question

Dome Metals has credit sales of $342,000 yearly with credit terms of net 45 days, which is also the average collection period. Assume the firm adopts new credit terms of 2/18, 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 10 percent. The new credit terms will increase sales by 10% because the 2% discount will make the firm's price competitive a. If Dome earns 20 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.) Net change in income b. Should the firm offer the discount? Yes No

Explanation / Answer

SOLUTION

(A) New sales = $342,000 * 110% = $376,200

Increase in profit from new sales = Profit percentage * Increase in sales

= 0.20 * ($376,200-$342,000)

= 0.20 * 34,200

= $6,840

Average accounts receivable balance without the discount

= Average collection period * AVerage daily sales

= 18 * (376,200 / 360)

= 18 * 1,045 = 18,810

Reduction in accounts receivable = $42,750 - $18,810 = 23,940

The $23,940 cash inflow from reducing accounts receivable will be used to reduce the firm's loan balance and it results in interest savings.

Interest savings = Interest rate * Loan reduction

= 10% * $23,940 = $2,394

Cost of discount = Discount rate * Sales

= 0.02 * $376,200 = $7,524

Net gain/ (Loss) = Increase in profit + Interest savings - Cost of discount

= $6,840 + $2,394 - $7,524

= $1,710

(B) Yes, the firm should offer the discount of 2%, because it will realize a gain of $1,710.

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