Lewis Enterprises is considering relaxing its credit standards to increase its c

Question

Lewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a result of the proposed relaxation, sales are expected to increase by 10% from 10,000 to 11,000 units during the coming year; the average collection period is expected to increase from 45 to 60 days; and bad debts are expected to increase from 1% to 3% of sales. The sale price per unit is $40, and the variable cost per unit is $31. The firms required return on equal-risk investments is 25%. Evaluate the proposed relaxation, and make a recommendation to the firm. (Note: Assume a 365-day year.)

Explanation / Answer

Additional profit contribution from sales: 1,000

additional units x ($40 - $31) = $ 9,000

Cost of additional investment in Receivables

Average investment, proposed plan: (11,000X31)/365 X 60* = $56,054                                         

Average investment, present plan: (10,000X31)/365 X 45 =38,219

Additional investment in A/R $17,835

Required return on investment x .25

Cost of additional investment in A/R= (4,459)

of additional bad debts: Bad debts, proposed plan (.03 x $40 x 11,000 units) =$13,200

Bad debts, present plan (.01 x $40 x 10,000 units)= 4,000

Cost of additional bad debts =(9,200)

Net loss from the proposed plan (==$4,659 ANSWER

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