In an effort to speed up the collection of receivables, Hill Publishing Company

Question

In an effort to speed up the collection of receivables, Hill Publishing Company is con-sidering increasing the size of its cash discount by changing its credit terms from "1/ 10, net 30" to "2/ 10, net 30" Currently, the companys collection period averages 43 days. Under the new credit terms, it is expected to decline to 28 days. Also, the percentage of customers who will take advantage of the cash discount is expected to increase from the current 50 percent to 70 percent with the new credit terms. Bad-debt losses currently average 4 percent of sales and are not expected to change signifi-cantly if Hill changes its credit policy. Annual credit sales are $ 3.5 million, the variable cost ratio is 60 percent, and the required pretax rate of return ( i. e., the opportunity cost) on receivables investment is 14 percent. The company does not expect its inven-tory level to change as a result of its proposed change in credit terms. Assuming that Hill does decide to increase the size of its cash discount, determine the following:

a. The earnings on the funds released by the change in credit terms

b. The cost of the additional cash discounts taken

c. The net effect on Hills pretax profits

Explanation / Answer

a. If the credit terms change, the funds to be released will be calculated as under : (Please note that all values are in $) Particulars Old Policy New Policy Annual Sales 3500000 3500000 Cash Discount 350000 700000 % of customers availing benefit 50% 70% Value in terms of customers who have availed benefit 175000 490000 Funds released by change in credit terms per new policy 315000 Earnings @ 14% on the funds 44100 b. Cost of additional cash discounts taken 315000 c. The net effect on Hills Pretax profits owing to a change in the policy Sales 3500000 Variable Costs -2100000 Gross Profit 1400000 Discounts availed -490000 Bad Debts @ 4% of sale value -140000 Pre Tax Profits after change in Policy 770000 Original Pre Tax Profits Sales 3500000 Variable Costs -2100000 Gross Profit 1400000 Discounts availed -175000 Bad Debts @ 4% of sale value -140000 Original Pre Tax Profits 1085000 Owing to a change in the policy, the pretax profits of Hills reduce by $ 315,000, which is equivalent to the cost of additional discounts taken.

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