17. 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?
To answer these questions, we'll go step-by-step:
a. To calculate the level of accounts receivable needed to support the sales expansion, we need to determine the increase in credit sales. Since the increase in sales is given as $80,000, and credit sales make up 100% of the increase, the credit sales increase would also be $80,000.
Next, we calculate the accounts receivable turnover by dividing net credit sales by the average accounts receivable:
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Since the turnover is given as five times, we can set up the following equation:
5 = $80,000 / Average Accounts Receivable
Rearranging the equation, we can solve for the average accounts receivable:
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 Collins's incremental aftertax return on investment, we need to determine the net income generated by the sales expansion and the incremental investment required.
The net income can be calculated as follows:
Net Income = Incremental Sales * (1 - Production and Selling Costs) * (1 - Collection Costs) * (1 - Income Tax Rate)
Net Income = $80,000 * (1 - 0.78) * (1 - 0.05) * (1 - 0.30)
Next, we calculate the incremental investment as the sum of the increase in accounts receivable and the increase in inventory:
Incremental Investment = Increase in Accounts Receivable + Increase in Inventory
Since we're given that no other asset buildup is required to service the new accounts, the increase in inventory would be zero. Thus:
Incremental Investment = Increase in Accounts Receivable + 0
To calculate the increase in accounts receivable, we can use the accounts receivable turnover:
Increase in Accounts Receivable = Average Accounts Receivable * Increase in Sales
Increase in Accounts Receivable = $16,000 * $80,000
Finally, we can calculate the incremental aftertax return on investment:
Incremental Aftertax Return on Investment = Net Income / Incremental Investment
c. To determine if Collins should liberalize credit if a 15 percent aftertax return on investment is required, compare the calculated incremental aftertax return on investment to the required return. If the incremental aftertax return is greater than or equal to 15 percent, Collins should liberalize credit.
d. To calculate the total incremental investment in accounts receivable and inventory to support an $80,000 increase in sales, we need to determine the increase in accounts receivable and the increase in inventory.
We've already calculated the increase in accounts receivable as $16,000. Since we're given that the inventory turnover is four times, we can use it to calculate the increase in inventory:
Increase in Inventory = Increase in Sales / Inventory Turnover
Increase in Inventory = $80,000 / 4
The total incremental investment would be the sum of the increase in accounts receivable and the increase in inventory.
e. Given the incremental aftertax return on investment calculated in part b and the total incremental investment calculated in part d, we can determine if Collins should extend more liberal credit terms. If the incremental aftertax return on investment is greater than or equal to the required return, then Collins should extend more liberal credit terms.
To answer these questions, we need to calculate various financial metrics and ratios. Let's go step by step.
a. To determine the level of accounts receivable needed to support the sales expansion, we need to calculate the increase in accounts receivable.
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Since the turnover is given as five times, we can calculate the Average Accounts Receivable as:
Average Accounts Receivable = Net Credit Sales / Accounts Receivable Turnover
Given the increase in sales as $80,000, we can calculate the net credit sales as:
Net Credit Sales = Increase in Sales / (1 + Increase in Accounts Receivable Turnover)
Substituting the values, we get:
Net Credit Sales = $80,000 / (1 + 5)
Next, we can calculate the increase in accounts receivable:
Increase in Accounts Receivable = Net Credit Sales / Accounts Receivable Turnover
Substituting the values, we get the level of accounts receivable needed to support the sales expansion.
b. To calculate Collins's incremental aftertax return on investment (ROI), we need to consider the incremental operating income and the incremental investment.
Incremental Operating Income = Sales Increase * (1 - Costs Percentage) * (1 - Uncollectible Percentage) - Collection Costs
The Costs Percentage is the sum of production costs and selling costs, given as 78%. The Uncollectible Percentage is given as 9%.
Incremental Investment = Increase in Accounts Receivable * (1 - Tax Rate)
The Tax Rate is given as 30%.
Now, we can calculate the Incremental Aftertax ROI:
Incremental Aftertax ROI = (Incremental Operating Income - Incremental Investment) / Incremental Investment
c. If a 15 percent aftertax ROI is required, we compare it with the calculated Incremental Aftertax ROI. If the calculated ROI is greater than or equal to 15 percent, then Collins should liberalize credit. Otherwise, they should not.
d. To determine the total incremental investment in accounts receivable and inventory, we need to consider the increase in accounts receivable and the increase in inventory.
The increase in accounts receivable was calculated in part a.
Increase in Inventory = Sales Increase / Inventory Turnover
Given that the inventory turnover is four times, we can calculate the increase in inventory.
Total Incremental Investment = Increase in Accounts Receivable + Increase in Inventory
e. To make a decision on whether to extend more liberal credit terms, we compare the Incremental Aftertax ROI (calculated in part b) with the required ROI of 15 percent. If the calculated ROI is greater than or equal to 15 percent, Collins can extend more liberal credit terms. Otherwise, they should not.
By following these calculations and comparisons, you can determine the answers to each question and make an informed decision.