Mooney Magical Mirror Manufacturing (4M, not to be confused with 3M) presently s

Question

Mooney Magical Mirror Manufacturing (4M, not to be confused with 3M) presently sells 20,000,000 units per year at a price of $60 per unit with per unit variable costs of $50 per unit. The company%u2019s average collection period is presently 36 days despite offering terms of net 30. It%u2019s bad debt expense is presently 0.5% of annual sales. In an effort to possibly increase sales, but more importantly speed up collection, the firm is considering changing its credit terms to 2/10 net 30. They estimate that sales will only increase by 2% as a result of the change since many of its competitors offer similar credit terms. It does expect, however, that 60% of its total sales will take advantage of the discount and in doing so will reduce the average collection period to 15 days. Furthermore, it is expected that the bad debt ratio will fall to 0.3% of sales. The firm%u2019s cost of capital is 14%. Given this information should Mooney Manufacturing change its credit terms? Explain why supporting your answer with numerical justification.

Explanation / Answer

EXISTING SCENARIO
Bad Debt = 0.5% = 0.005*(20m*60) = $6m

NEW SCENARIO
Bad Debt = 0.3% = 0.005*(20m*60) = $3.6m
Expected Discounts = 0.02*(0.6*20m*60) = $14.4m
Total Cost = $3.6m + $14.4m = $18m

SINCE, THE NEW SCHEME WILL COST THE COMPANY MORE IT SHOULD NOT BE STARTED.

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