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?
go on th eenternet
To answer these questions, we need to calculate several components and use them to find the level of accounts receivable, incremental after-tax return on investment, and the total incremental investment in accounts receivable and inventory. Let's break down each part step by step:
a. To find the level of accounts receivable needed to support the sales expansion, we use the accounts receivable turnover ratio. The formula for accounts receivable turnover is: Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable.
Given that the accounts receivable turnover is five times, and the increase in sales is $80,000, we can calculate the average accounts receivable needed:
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
5 = $80,000 / Average Accounts Receivable
Rearranging the formula, we find:
Average Accounts Receivable = $80,000 / 5
Average Accounts Receivable = $16,000
Therefore, the level of accounts receivable needed to support this sales expansion is $16,000.
b. To calculate the incremental after-tax return on investment, we need to consider the net profit and the total investment. The formula for after-tax return on investment is: After-Tax Return on Investment = (Net Profit - Income Tax) / Total Investment.
Given that collection costs are 5% of new sales, production and selling costs are 78% of new sales, accounts receivable turnover is five times, and income taxes are 30%, we can calculate the incremental after-tax return on investment.
Net Profit = (1 - Collection Costs - Production and Selling Costs) * Increase in Sales
Net Profit = (1 - 0.05 - 0.78) * $80,000
Total Investment = (Accounts Receivable + Inventory) * (1 - Accounts Receivable Turnover)
Accounts Receivable = Average Accounts Receivable * Increase in Sales
Accounts Receivable = $16,000 * $80,000
Total Investment = ($16,000 + (Inventory Turnover * Increase in Sales)) * (1 - 5)
Total Investment = ($16,000 + (4 * $80,000)) * (1 - 5)
After-Tax Return on Investment = (Net Profit - Income Tax) / Total Investment
After-Tax Return on Investment = ((1 - 0.05 - 0.78) * $80,000 - (0.30 * ((1 - 0.05 - 0.78) * $80,000))) / ((($16,000 + (4 * $80,000)) * (1 - 5))
By performing the calculations, you can find the incremental after-tax return on investment.
c. Now that we have calculated the incremental after-tax return on investment, we can compare it to the required return on investment. If the required return on investment is 15%, and the calculated after-tax return on investment is higher than 15%, Collins should liberalize credit. Otherwise, it should not.
d. To find the total incremental investment in accounts receivable and inventory, we need to calculate the inventory level and add it to the accounts receivable level.
Inventory Level = Inventory Turnover * Increase in Sales
Inventory Level = 4 * $80,000
Total Incremental Investment = Accounts Receivable + Inventory
Total Incremental Investment = ($16,000 + (4 * $80,000))
By performing the calculations, you can find the total incremental investment in accounts receivable and inventory.
e. Finally, given the calculated income from part b and the total incremental investment from part d, we can determine if Collins should extend more liberal credit terms. If the income is greater than the total incremental investment, it may be financially beneficial.
By considering the calculated income and total incremental investment, you can make a decision on whether Collins should extend more liberal credit terms.
Note: It is important to perform the calculations accurately and adjust the formulas based on the specific details provided in the question.