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Credit Standards at Magic Enterprises

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Magic Enterprises is evaluating the profitability of easing its credit standards. Under its current policy, the firm extends credit only to the firms in credit risk groups 1, 2, 3, and 4. By not extending credit to groups 5 and 6, the firm estimates it loses $1,380,000 in sales annually. The firm's variable cost ratio is 0.82, and the firm requires a 23 percent pretax rate of return on its investments in current assets. If credit is extended to group 5 and group 6, additional inventory investments of $170,000 and $106,000 respectively will be required. Magic wants to determine if extending credit to the one or both two groups would be profitable.

Credit Average
Risk Credit Collection Bad Debt
Group Sales Period (days) Loss Ratio%
1 $2,200,000 23 --
2 3,050,000 28 .20
3 1,720,000 36 .55
4 1,125,000 44 2
5 850,000 59 8
6 530,000 78 14

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Extending the credit to the 5th risk group

1) Increase in Contribution= Sales-Variable costs=( 100%-82%)*850000 = $153,000.00

2) Less Incremental Bad debts= 8%*850000 = $68,000.00

Earnings before ...

Solution Summary

The solution discusses how Magic Enterprises determines their credit sales.

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