Dome Metals has credit sales of $450,000 yearly with credit terms of net 45 days

Question

Dome Metals has credit sales of $450,000 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 12 percent. The new credit terms will increase sales by 20 percent because the discount will make the firm's price competitive.

A) If Dome earns 15 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.)

Explanation / Answer

Increase in Sales = 90000$

Increase in Profits because of increased sales before discount (90000$ * 15%) = 13500$

Discount allowed because of new discount policy (540000 * 2%) = $10800

Average receivables during the year before change in discount policy (450000 * 45/360) = 56250$

Average receivables during the year after change in discount policy (540000 * 18/360) = 27000$

Interest saved on surplus fund [(56250-27000) * 12%] = 3510

Net change in income would be

Increase in profit due to increased sales     13500$

less: Cash discount allowed                           10800$

Add: Saving of interest on bank loan               3510$

                                                                    =  6210$

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