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 4 times.
Assume income taxes of 35 percent and an increase in sales of $100,000
No other asset buildup will be required to service the new accounts.
a What is the level of accounts receivable 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 a $100,000 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?
Bad debts (from new accounts) 9%
Collection costs (of new sales) 5%
Production and selling costs 78%
Accounts Receivables turnover (times) 4
Income taxes 35%
Increase in sales $100,000
Inventory Turnover (times) 4
a Required level of accounts receivables $25,000
b Incremental after tax return on investment 20.80%
c Yes, Collins should liberalize credit if a 15% after tax return on investment is required.
d Total Incremental Investments $50,000
e Incremental after tax return on investment 10.40%
No, Collins should not liberalize credit if a 15% after tax reurn on investment is required.
To answer these questions, we need to calculate various figures related to accounts receivable, investment, and return on investment. Let's calculate each part step by step:
a) To find the level of accounts receivable to support sales expansion, we need to calculate the total increase in accounts receivable. We can calculate it using the accounts receivable turnover:
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Given that the accounts receivable turnover is 4 times, we can rearrange the formula to find Average Accounts Receivable:
Average Accounts Receivable = Net Credit Sales / Accounts Receivable Turnover
Since the increase in sales is $100,000 and collection costs are 5% of new sales, the net credit sales can be calculated as follows:
Net Credit Sales = New Sales - Collection Costs
Net Credit Sales = $100,000 - (5% * $100,000)
Now we can calculate the average accounts receivable:
Average Accounts Receivable = ($100,000 - (5% * $100,000)) / 4
b) To find Collins's incremental after-tax return on investment, we need to calculate the incremental investment and the incremental after-tax income.
Incremental Investment = Increase in Accounts Receivable + Increase in Inventory
Given that the increase in sales is $100,000, and inventory turnover is four times, we can calculate the increase in inventory as follows:
Increase in Inventory = $100,000 / Inventory Turnover
Next, we need to calculate the increase in accounts receivable, which was already calculated in part a.
Now we can calculate the incremental investment:
Incremental Investment = Increase in Accounts Receivable + Increase in Inventory
After calculating the incremental investment, we need to find the incremental after-tax income:
Incremental After-Tax Income = Increase in Sales - Collection Costs - Production and Selling Costs - Incremental Investment*(1 - Tax Rate)
Given that the tax rate is 35%, we can calculate the incremental after-tax income:
Incremental After-Tax Income = $100,000 - (5% * $100,000) - 78% * $100,000 - Incremental Investment * (1 - 35%)
c) To determine if Collins should liberalize credit if a 15% after-tax return on investment is required, we compare the incremental after-tax return on investment (from part b) with the required return on investment of 15%. If the incremental after-tax return on investment is higher than 15%, it would be justified to liberalize credit. Otherwise, it would not be justified.
d) To calculate the total incremental investment in accounts receivable and inventory to support a $100,000 increase in sales, we can add the increase in accounts receivable (calculated in part a) to the increase in inventory (calculated in part b).
Total Incremental Investment = Increase in Accounts Receivable + Increase in Inventory
e) To determine if Collins should extend more liberal credit terms given the income determined in part b and the investment determined in part d, we need to compare the incremental after-tax income with the total incremental investment. If the incremental after-tax income is higher than the total incremental investment, it would be beneficial to extend more liberal credit terms. Otherwise, it may not be beneficial.
By calculating the above steps, we can answer each question and make an informed decision.