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Impact of more liberal credit policy

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 needed to support this sales expansion?

b. What would be Collins's incremental after-tax return on investment?
c. Should Collins liberalize credit if a 15 percent after-tax 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 an $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?

Solution Preview

a.What is the level of accounts receivable needed to support this sales expansion?

Account receivable turnover=5
Increase in sales=$80,000
Investment required in account receivable=Increase in sales/Account receivable turnover
Accounts receivable required=80000/5=$16,000

b.What would be Collins's incremental after tax return on investment?

Let us calculate change in after tax profit.
Increase in sales=$80,000
Less Uncollectable accounts @9%=-$7,200
Less cost of ...

Solution Summary

Solution discusses the impact of more liberal credit policy on aftertax returns.