Henderson Office Supply is considering a more liberal credit policy to increase

Question

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 8 percent of the new accounts will be uncollectible. Collection costs are 3 percent of new sales, production and selling costs are 80 percent, and the accounts receivable turnover is five times. Assume income taxes of 35 percent and an increase in sales of $82,000. No other asset buildup will be required to service the new accounts.  

a. What additional investment in accounts receivable is needed to support this sales expansion?

b. What would be Henderson’s incremental aftertax return on investment? (Input your answer as a percent rounded to 2 decimal places.)

c. Should Henderson liberalize credit if a 18 percent aftertax return on investment is required?

Assume that Henderson also needs to increase its level of inventory to support new sales and that the inventory turnover is two times.  

d. What would be the total incremental investment in accounts receivable and inventory needed to support a $82,000 increase in sales?

e. Given the income determined in part b and the investment determined in part d, should Henderson extend more liberal credit terms?

Explanation / Answer

a) Accounts receivable turnover = Sales / Accounts receivable

or, 5 = $82000 / Accounts receivable

or, Investment in Accounts receivable = $82000 / 5 = $16400

b)

return on investment = Incremental earnings after tax / investment in receivables = $4797 / $16400 = 0.2925 or 29.25%

c) Yes, it should liberalize credit as it is getting a higher return of 29.25% in comparison to 18%.

d) Inventory turnover = Sales / inventory

or, 2 = $82000 / Inventory

or, Inventory = $82000 / 2 = $41000

Total incremental investment = investment in accounts receivables + investment in inventory = $16400 + $41000 = $57400

e) Return on investment = $4797 / $57400 = 0.0836 or 8.36%

Since this return is less than the required return of 18%, the company should not liberalize credit.

Incremental sales $82000 Less: Production and selling costs ($82000 x 80%) $65600 Less: Collection costs ($82000 x 3%) $2460 Less: Uncollectible sales (8% x $82000) $6560 Incremental earnings before tax $7380 Less: Tax @35% $2583 Incremental earnings after tax $4797

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