Fin 200 Credit Policy Decisions Checkpoint Week 6

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 five times. Assume income taxes of 30 percent and an increase in sales of $80,000. 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 $80,000 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?

7-17. Solution:

Collins Office Supplies

a.

b. Added sales $ 80,000

Accounts uncollectible (9% of new sales) – 7,200

Annual incremental revenue $ 72,800

Collection costs (5% of new sales) – 4,000

Production and selling costs (78% of new sales) – 62,400

Annual income before taxes $ 6,400

Taxes (30%) – 1,920

Incremental income after taxes $ 4,480

Return on incremental investment = $4,480/$16,000 = 28%

c. Yes! 28% exceeds the required return of 15%.

7-17. (Continued)

d.

Total incremental investment

Inventory $20,000

Accounts receivable 16,000

Incremental investment $36,000

$4,480/$36,000 = 12.44% return on investment

e. No! 12.44% is less than the required return of 15%.