You have been asked to assess the expected financial impact of each of the follo

Question

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 $160,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 10% are projected to be uncollectible. Additional collection costs are projected to be 2% of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 78% of sales. Your firm expects to pay a total of 40% of its income after expenses in taxes.

1)Compute the incremental income after taxes that would result from these projections:

2)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…

3)Compute the additional investment in Accounts Receivable

4)Compute the incremental Return on New Investment

5)If your company requires a 20% 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.

1)If the company currently averages $40,000 in collections per day, how many dollars will this suggested cash management system free up?

2)If all freed up dollars would be used to pay down debt that has an interest rate of 6%, how much money could be saved each year in interest expense?

3)Do the numbers suggest that this new system should be implemented if its total annual cost is $5200? Explain.

Explanation / Answer

Since, there are multiple parts to the question, the first five have been answered.

________

Part 1)

The incremental income after taxes is calculated with the use of following table:

_______

Part B)

The incremental return on sales is calculated as follows:

Incremental Return on Sales = (Incremental Sales*10%)/Incremental Sales*100 = (160,000*10%)/160,000*100 = 10%

_______

Part 3)

The additional investment in accounts receivable is calculated as follows:

Additional Investment in Accounts Receivable = Incremental Sales/Receivable Turnover Ratio = 160,000/4 = $40,000

_______

Part 4)

The incremental return on new investment is calculated as follows:

Incremental Return on New Investment = (Incremental Sales*10%)/Increase in Accounts Receivable*100 = (160,000*10%)/40,000*100 = 40%

_______

Part 5)

Yes, the trade credit should be extended to new customers as incremental return on new investment (40%) is higher than the required rate of return (20%).

Income after Production and Selling Costs (160,000*(1-78%)) 35,200 Less Loss on Uncollectibe Items (160,000*10%) 16,000 Additional Collection Cost (160,000*2%) 3,200 Incremental Income after Taxes $16,000

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