East Lansing Appliances (ELA) expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and bad debt loss percentage is 5 percent. Since ELA wants to improve its profitability, the treasurer has proposed that the credit period be shortened to 15 days. This change would reduce expected sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days. Expected bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60 percent, and the cost of capital is 15 percent.
A. What would be the incremental cost of carrying receivables if this change were made?
B. What are the incremental pre-tax profits from this proposal?
Average Receivables under current policy = Sales*DSO/365 = 15*60/365=2.466 million
Interest cost on receivables = 15%*2.466 million = 0.3699 million
Bad debt loss = bad debt loss percentage * accounts receivables = 5%*2.466 million = 0.1233 ...
The incremental pre-tax profits are determined.