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Incremental Credit Policy

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In order to increase sales from their present annual $35million, ABC Company, a retailer, is considering more liberal credit standards. Currently, the firm has an average collection period of 30 days. It believes that with increasingly liberal credit standards, the following will result:

Credit Policy
Increase in sales from previous level (in millions) $5.5 $4.5 $2.3 $1.1
Average Collection period for incremental sales (Days) 45 60 90 150
Bad-debt loses on incremental sales 2% 4% 7% 10%

The prices of its product average $30 per unit, and variable cost average per unit is $25. If the company has a before-tax opportunity cost of 20%, which credit policy should be pursued?

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Incremental Credit Policy

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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 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 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?

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