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 $150,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 7% are projected to be uncollectible. Additional collection costs are projected to be 3% of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 80% of sales. Your firm expects to pay a total of 40% 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 3 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% 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 $60,000 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%, 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 $5200? Explain.

Explanation / Answer

Proposal 1 :-

Sales are expected to increase : $150,000

Production and seling cost for these sales :- 80% of 150,000 = $120,000

Additional collection cost 3% of 150,000 = $4,500

Provision for bad debt 7% of 150,000 = $10,500

So, now profit before tax will be 150,000-120,000-4,500-10,500 = $15,000

Tax rate 40%

Profit after tax :- 15,000-40% of 15,000 = $9.000

Increemental return on sales :- 9,000/150,000 = 6%

If we consider accounts receivable turnover ratio of 3:1 and the incremental sales is $150,000.

Incremental investment in accounts receivable = 150,000/3 = $50,000

Incremental return on new investment = 9,000/50,000 = 18%.

If the company required 20% rate of return on all new proposals of investment, then because the return with this proposal is only 18%, we are not going to accept this proposal.

Proposal 2

With the new system in place, the average collection days (i.e the days required to collect money from debtors) reduce by 2 days and the average collection per day is $60,000.

This proposal can free up 60,000*2 = $120,000 worth of investment in trade receivables.

If this freed up cash will be used to pay down debt for which the company is paying 6% interest rate then the company will be saving $120,000*6% = $7,200 interest expense.

Interest expense saves our taxes, so to calculate interest saving we need to do it post tax.

So, net savings in interest = 7,200-40% of 7,200 = $4,320.

If the total annual cost for this system is $5,200 and the net saving in interest from this system is only $4,320, then this system is not beneficial for the company.

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