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Computing after tax return of a promotional compaign

Global Services is considering a promotional campaign that will increase annual credit sales by $400,000. The company will require investments in accounts receivable, inventory, and plant and equipment. The turnover for each is as follows:

Accounts r receivable - 4x

Inventory - 8x

Plant & Equipment - 2x

All 400,000 of the sales will be collectible. However, collection costs will be 4% of sales, and production and selling costs will be 76% of sales. The cost to carry inventory will be 8% of inventory. Depreciation expense on plant & equipment will be 5% of plant & equipment. The tax rate is 30%.

a. Compute the investments in accounts receivable, inventory, and plant & equipment based on turnover ratios. Add the three together.

b. compute the accounts receivable collection costs and production and selling costs and add the two figures together.

c. Compute the cost of carrying inventory.

d. Compute the depreciation expense on the new plant & equipment.

e. add together all the costs in parts, b, c, d.

f. Subtract the answer from part e from the sales figure of 400,000 to arrive at income before taxes. Subtract taxes at the rate of 30% to arrive at income after taxes.

g. Divide the aftertax return figure in part f by the total investment in part a. If the firm has a required return on investment of 12%, should it undertake the promotional campaign described throughout this problem.

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Solution:

a. Compute the investments in accounts receivable, inventory, and plant & equipment based on turnover ratios. Add the three together.
Investment required in accounts receivable=Increase in sales/Accounts receivable turnover
=400000/4=$100000
Investment required in inventory=400000/8= $50000
Investment required in Plant and Equipment=400000/2=$200000
Total ...

Solution Summary

Solution describes the steps for calculating investments in accounts receivable, inventory and machinery to meet the requirements of increase in estimated credit sales. It also determines whether such investments meet the company's required rate of return criteria.

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