BUSI 320 Comprehensive Problem 2 2016 Summer B You have been asked to assess the

Question

BUSI 320 Comprehensive Problem 2 2016 Summer B You have been asked to assess the expected financial impact of each of the following proposals to improve the profitability of credit sales made by your company. Each proposal is independent of the other. Answer all questions. Showing your work may earn you partial credit. Proposal #1 would extend trade credit to some customers that previously have been denied credit because they were considered poor risks. Sales are projected to increase by dollar 160, 000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 10 percentage are projected to be uncollectible. Additional collection costs are projected to be 2 percentage of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 78 percentage of sales. Your firm expects to pay a total of 40 percentage of its income after expenses in taxes Compute the incremental income after taxes that would result from these projections: Compute the incremental Return on Sales if these new credit customers are accepted: If the receivable turnover ratio is expected to be 4 to 1 and no other asset buildup is needed to serve the new customers... Compute the additional investment in Accounts Receivable Compute the incremental Return on New Investment If your company requires a 20 percentage Rate of Return on Investment for all proposals, do the numbers suggest that trade credit should be extended to these new customers? Explain Proposal #2 would establish local collection centers throughout the region to decrease the time it takes to convert credit payments that are mailed in by check to cash. It is estimated that establishing these collection centers would reduce the average collection time by 2 days. If the company currently averages dollar 40, 000 in collections per day, how many dollars will this suggested cash management system free up? If all freed up dollars would be used to pay down debt that has an interest rate of 6 percentage, how much money could be saved each year in interest expense? Do the numbers suggest that this new system should be implemented if its total annual cost is dollar 5200? Explain.

Explanation / Answer

Answer:

Solution for Proposal # 1

1) Calculation of Incremental income after tax:

Explanation:

a) Uncollectible receivables:

Uncollectible receivables = Incremental Sales * percentage of uncollectible

Uncollectible receivables = $160000 * 10% = $16000

b) Additional collection cost:

Additional collection cost = Incremental Sales * Percentage of collection cost

Additional collection cost = $160000 * 2%=$3200

c) Production and selling cost:

Production and selling cost = Incremental sales * Percentage of production and selling cost

Production and selling cost = $160000 * 78% = $124800

d) Income tax:

Income taxes = Incremental income before tax * Tax rate

Income taxes = $16000 * 40% = $6400

2) Incremental return on sales = Incremental income after tax / Incremental sales

Incremental income after tax = $9600 (calculated in part 1 above)

Incremental sales = $160000 (Given)

Incremental return on sales = $9600/$160000

Incremental return on sales = 0.06

Incremental return on sales = 6%

3) Additional investment in Accounts Receivables = Incremental Sales/ Receivable turnover ratio

Additional investment in Accounts Receivables = $160000 * (1/4)

Additional investment in Accounts Receivables = $40000

Therefore, Accounts Receivable would increase by $40000.

4) Incremental return on new investment = Incremental income after tax / Additional investment in Accounts Receivables

Incremental income after tax = $9600 (calculated in part 1 above)

Additional investment in Accounts Receivables = $40000 (calculated in part 3 above)

Incremental return on new investment = $9600/$40000

Incremental return on new investment = 0.24

Incremental return on new investment = 24%

5) Yes, Because the incremental return on new investment of 24% is higher than the stated 20% rate of return on investment. Therefore, the trade credit should be extended to these new customers.

Solution for Proposal # 2

1) Required dollars to be freed up = Average collection per day * No. of days

Required dollars = $40000 * 2 days =$80000

2) Money could be saved each year in interest expense = Freed up dollars * Interest rate

Money could be saved each year in interest expense = $80000 *6%

Money could be saved each year in interest expense = $4800

3) No, this new system should not be implemented as the cost of implementation of $5200 is higher than the benefit of $4800.

Incremental sales $ 1,60,000.00 Less: Uncollectible receivables $     16,000.00 Less: Additional collection cost $       3,200.00 Less: Production and selling cost $ 1,24,800.00 Incremental income before taxes $     16,000.00 Less: Income tax $       6,400.00 Incremental income after taxes $       9,600.00

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