In an effort to speed up the collection of receivables, Hill Publishing Company
ID: 2773430 • Letter: I
Question
In an effort to speed up the collection of receivables, Hill Publishing Company is considering increasing the size of its cash discount by changing its credit terms from "1/10, net 30" to "2/10, net 30". Currently, the company's 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 with the new credit terms. Bad-debt losses currently average 4 percent of sales and are not expected to change significantly 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 receivable investment is 14 percent. The company does not expect its inventory 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 discounts, determine the following:
1.The earning on the funds released by the change in credit terms
2.The cost of the additional cash discounts taken
3.The net effect on Hill's pretax profits
Explanation / Answer
Amount of Funds released by change in credit terms = $ 145,833.34
Amount of earnings (costs reduced) on Accounts Receivable = $ 20,416.67
Additional cost of Discount due to change in terms = $ 30,240
Net Effect on Pre-tax Profits = $ 8,320.67
working
Existing Terms
Credit Terms = “1/10, net 30 or 1% discount for 10 days and payable in 30 days if discount not availed
Company’s average Collection Period - 43 days
% of customers taking advantage of credit terms = 50
Bad-debt losses = 4%
Annual Credit Sales = $ 3.5 Million
Changed Terms – “2/10, net 30 that is discount rate 2%
Expected Collection Period – 28 days
% of customers taking advantage of credit terms = 70
Calculation of Discount Value under existing credit terms
Annual Credit Sales = $ 3,500,000
Less Bad Debts 4% = $ 3,500,000 * 4% = $ 140,000
Credit Sales Net of bad debts = $ 3,500,000 - $ 140,000 = $ 3,360,000
Existing amount of Discount availed by customers = $ 3,360,000 * 50% * 1% = $ 16,800
Expected amount of Discount availed by customers = $ 3,360,000 * 70% * 2% = $ 47,040
Additional cost of Discount due to change in terms = $ 47,040 - $16,800 = $ 30,240
Accounts Receivable under existing Terms = $ 3,500,000 * 43/360 = $ 418,055.56
Accounts Receivable under new terms = $3,500,000 * 28/360 = $ 272,222.22
Amount of Funds released by change in credit terms = AR existing – AR changed
= $ 418055.56 - $ 272,222.22
= $ 145,833.34
Opportunity cost on receivable investment = 14%
Amount of earnings (costs reduced) on AR = $ 145,833.34 * 14% = $ 20,416.67
Prior
After
Credit Sales
3500000.00
3500000.00
Less Discount
16800.00
47040.00
Cash
3483200.00
3452960.00
Variable Cost
2089920.00
2071776.00
Bad Debt Losses
140000.00
140000.00
Interest on AR investment
58527.78
38111.11
Profit Before Tax
1194752.22
1203072.89
Net Effect on Pre-tax Profits = PBT after change in credit terms – PBT before change in credit terms
= $ 1,203,072.89 - $ 1,194,752.22 = $ 8,320.67
Prior
After
Credit Sales
3500000.00
3500000.00
Less Discount
16800.00
47040.00
Cash
3483200.00
3452960.00
Variable Cost
2089920.00
2071776.00
Bad Debt Losses
140000.00
140000.00
Interest on AR investment
58527.78
38111.11
Profit Before Tax
1194752.22
1203072.89
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