Question

Collins Office Supplies is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible.
Collection costs are 5 percent of new sales, production and selling costs are 78 percent, and accounts receivable turnover is 4 times.
Assume income taxes of 35 percent and an increase in sales of $100,000
No other asset buildup will be required to service the new accounts.
a What is the level of accounts receivable to support this sales expansion?
b What would be Collins’s incremental aftertax return on investment?
c Should Collins liberalize credit if a 15 percent aftertax return on investment is required?
Assume Collins also needs to increase its level of inventory to support new sales and that inventory turnover is four times.
d What would be the total incremental investment in accounts receivable and inventory to support a $100,000 increase in sales?
e Given the income determined in part b and the investment determined in part d, should Collins extend more liberal credit terms?

Answer 1

Bad debts (from new accounts) 9%
Collection costs (of new sales) 5%
Production and selling costs 78%
Accounts Receivables turnover (times) 4
Income taxes 35%
Increase in sales $100,000
Inventory Turnover (times) 4

a Required level of accounts receivables $25,000

b Incremental after tax return on investment 20.80%

c Yes, Collins should liberalize credit if a 15% after tax return on investment is required.

d Total Incremental Investments $50,000

e Incremental after tax return on investment 10.40%
No, Collins should not liberalize credit if a 15% after tax reurn on investment is required.