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?
THis is more of a question how did you get the inventory question in part D?
answer to your question you take collection cost 5% of new sales which is 4,000 add 16,000 which is your a/c fiqure you got sales divided by a/c turnover which equal 20,000 which is your inventory..
a. To determine the level of accounts receivable needed to support the sales expansion, we need to calculate the increase in accounts receivable resulting from the increase in sales.
Accounts receivable turnover is given as five times, which means that the accounts receivable turnover period is 365/5 = 73 days.
The average accounts receivable balance can be calculated using the following formula:
Average Accounts Receivable = (Sales / 365) * Accounts Receivable Turnover
Given that the increase in sales is $80,000, we can calculate the increase in accounts receivable as follows:
Increase in Accounts Receivable = Average Accounts Receivable * Increase in Sales
b. To determine Collins's incremental aftertax return on investment, we need to calculate the incremental profit generated from the sales expansion and then apply the tax rate.
Incremental Profit = Increase in Sales * (1 - Collection Costs - Production and Selling Costs - Uncollectible Accounts)
Incremental Aftertax Profit = Incremental Profit * (1 - Tax Rate)
c. To decide whether Collins should liberalize credit, we compare the incremental aftertax return on investment with the required return.
Incremental Aftertax Return on Investment = Incremental Aftertax Profit / Incremental Investment
If the incremental aftertax return on investment is higher than the required return, Collins should liberalize credit. Otherwise, it should not.
d. To calculate the total incremental investment in accounts receivable and inventory, we need to determine the increase in inventory resulting from the sales expansion and add it to the increase in accounts receivable.
Increase in Accounts Receivable and Inventory = Increase in Accounts Receivable + Increase in Sales / Inventory Turnover
e. Given the incremental aftertax return on investment and the total incremental investment, we can decide whether Collins should extend more liberal credit terms. If the incremental aftertax return on investment is higher than the required return, Collins should extend more liberal credit. Otherwise, it should not.
a. Investment in accounts receivable =
b. Added sales $ 80,000
Accounts uncollectible (9% of new sales) – 7,200
Annual incremental revenue $ 72,800
Collection costs (5% of new sales) – 4,000
Production and selling costs
(78% of new sales) – 62,400
Annual income before taxes $ 6,400
Taxes (30%) – 1,920
Incremental income after taxes $ 4,480
Return on incremental investment = $4,480/$16,000 = 28%
c. Yes! 28% exceeds the required return of 15%.
d. Investment in inventory =
Total incremental investment
Inventory $20,000
Accounts receivable 16,000
Incremental investment $36,000
$4,480/$36,000 = 12.44% return on investment
e. No! 12.44% is less than the required return of 15%.