The new credit manager of Kay's Department store plans to liberalize the firm's credit policy. The firm currently generates credit sales of $575,000 annually. The more lenient credit policy is expected to produce credit sales of $750,000. The bad debt losses on additional sales are projected to be 5% despite an additional$15,000 collection expenditure. The new manager anticipates production and selling costs other than additional bad debt and collection expenses will remain at the 85% level. The firm is in the 34% tax bracket.
a. If the firm maintains its receivables turnover of 10 times, how much will the receivables balance increase?
b. What would be Kay's incremental after-tax return on investment?
c. Assuming additional inventory of $35,000 is required to support the additional sales, compute the after-tax return on investment.
35,0000
a. To calculate the increase in the receivables balance, we need to find the difference between the credit sales under the new policy and the current credit sales.
Current credit sales: $575,000
New credit sales: $750,000
Increase in credit sales: $750,000 - $575,000 = $175,000
b. To calculate the incremental after-tax return on investment, we need to calculate the increase in net profits due to the credit policy change and apply the tax rate.
Increase in net profits = Increase in credit sales * (1 - Bad debt losses) * (1 - Tax rate)
Increase in net profits = $175,000 * (1 - 0.05) * (1 - 0.34)
c. To compute the after-tax return on investment, we need to calculate the incremental net profits after considering the additional inventory requirement and apply the tax rate.
Incremental net profits = Increase in credit sales * (1 - Bad debt losses) * (1 - Production and selling costs) * (1 - Tax rate)
Incremental net profits = $175,000 * (1 - 0.05) * (1 - 0.85) * (1 - 0.34)
After obtaining the incremental net profits, we can calculate the after-tax return on investment by dividing the incremental net profits by the additional investment in inventory.
After-tax return on investment = Incremental net profits / Additional investment in inventory
To answer these questions, we will need to calculate several values and perform some calculations. Let's break down the steps to find the answers:
a. To calculate the increase in the receivables balance, we need to find the difference between the credit sales under the new policy ($750,000) and the current credit sales ($575,000). Therefore, the increase in credit sales is $750,000 - $575,000 = $175,000.
b. To calculate the incremental after-tax return on investment, we need to consider the additional bad debt losses, collection expenses, and the change in credit sales.
1. Additional bad debt losses: The projected bad debt losses on additional sales are 5% of $175,000, which is $8,750.
2. Additional collection expenses: The new manager anticipates an additional $15,000 collection expenditure.
3. Change in credit sales: The increase in credit sales is $175,000.
Now, we can calculate the incremental after-tax return on investment.
1. Calculate the profit on additional sales: ($175,000 - $8,750 - $15,000) * (1 - 0.34) = $146,850.
2. Calculate the incremental investment: $35,000 (additional inventory) + $8,750 (additional bad debts) + $15,000 (additional collection expenses) = $58,750.
3. Calculate the incremental after-tax return on investment: $146,850 / $58,750 = 2.5 (rounded to 2 decimal places) or 250%.
c. To calculate the after-tax return on investment considering the additional inventory of $35,000, we need to modify the calculations from part b.
1. Calculate the profit on additional sales: ($175,000 - $8,750 - $15,000 - $35,000 * 0.85) * (1 - 0.34) = $113,935.
2. Calculate the incremental investment: $35,000 (additional inventory) + $8,750 (additional bad debts) + $15,000 (additional collection expenses) = $58,750.
3. Calculate the after-tax return on investment: $113,935 / $58,750 = 1.94 (rounded to 2 decimal places) or 194%.
Therefore, the answers are:
a. The receivables balance will increase by $175,000.
b. The incremental after-tax return on investment is 250%.
c. The after-tax return on investment, considering additional inventory, is 194%.