Question 12: Working Capital Management Jimmy Cricket Limited has annual sales r

Question

Question 12: Working Capital Management Jimmy Cricket Limited has annual sales revenue of $40 million. All sales made by the business are on credit and, currently, credit terms are negotiable by the clients. Presently, bad debts amount to $500,000 per year. On average the settlement period for accounts receivable is 80 days. The accounts receivables are financed through an overdraft facility with a 6% rate of interest per year Tho management s presenty reviewing the credit policies to determine if there is amore eficient ancd profitable alternative. Senio r management have only forwarded a single proposal to the board of directors concerning the management of credit. It is proposed that that clients should be given a 3% discount ifthey pay within 20 days. For those that do not pay within the required period, a maximum of 80 days credit will be given. The credit department believes that clients that account for 45% of the sales will take advantage of the discount by paying at the end of the discount period. The remaining clients will pay at the end of the 80 day limit. The credit department is of the opinion that bad debts can be effectively eliminated through the adoption of the revised policies, and by employing stricter credit investigation procedures that will cost an additional S1,200,000 per year The credit department is confident that the proposed policy changes will not impact sales revenue. Required: Calculate the net annual cost (savings) to the company of abandoning its existing credit policies in favor of adopting the alternative proposal for credit control.

Explanation / Answer

Annual Sales Turnover is 40,000,000 which is the Actuals without Discount
To Find out the Level of Investment for particular period you need to calculate the Amount x (Number of days/Number of Days in a year)
So for
(a) Current Level of Investment the calculations would be 40,000,000 x (80/365) = 8,767,123
(b) Proposed Level of Investment (Takes Advantage of Discount) the calculations would be 18,000,000 x (20/365) = 986,301
(c) Proposed Level of Investment (Do not Takes Advantage of Discount) the calculations would be 22,000,000 x (80/365) = 4,821,918

So the Investment - (Current + Proposed Level) = Reduction in Overdraft (Level of Investment)
Which is 8,767,123 - (986,301 + 4,821,918) = 2,958,904

Now we also save the overdraft interest of 6% on 2,958,904 = 177,534.25

The cost of cash discount is 45% (The percentage of people who will opt for Discount) of 40,000,000 which is 18,000,000 on which 3% (the Discount being given) is 540,000

Then comes the additional cost of credit administration which is 1,200,000

We still have Bad debt Savings of 500,000 and Interest Saving of 177,534.25

So, the Net cost will be equal to Cost of Cash Discount + Additional Cost of Credit Administration - Savings
Which will be, 540,000 + 1,200,000 - (500,000 + 177,534.25) = 1,062,465.75

Hence, the Net Cost of the Policy Each Year would be $1,062,465.75

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