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 after tax return on investment?
c. Should Collins liberalize credit if a 15 percent after tax 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?
If you tried to "cut and paste" something, it rarely works here. You need to type everything out.
Sra
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.
First, we calculate the increase in sales by multiplying the sales increase ($80,000) by the production and selling costs (78%):
Increase in sales = $80,000 * 0.78 = $62,400
Next, we divide the increase in sales by the accounts receivable turnover to find the increase in accounts receivable required:
Increase in accounts receivable = $62,400 / 5 = $12,480
Therefore, the level of accounts receivable needed to support the sales expansion is $12,480.
b. To calculate Collins's incremental after tax return on investment, we need to subtract the incremental costs and taxes from the incremental sales:
Incremental profit before tax = Increase in sales - Collection costs - Incremental production and selling costs
Incremental profit before tax = $62,400 - ($62,400 * 0.05) - ($62,400 * 0.78) = $10,968
Next, we calculate the after-tax profit by deducting income taxes:
After-tax profit = Incremental profit before tax * (1 - tax rate)
After-tax profit = $10,968 * (1 - 0.30) = $7,677.60
To compute the incremental investment, we multiply the increase in accounts receivable by (1 - the accounts receivable uncollectible rate):
Incremental investment = Increase in accounts receivable * (1 - accounts receivable uncollectible rate)
Incremental investment = $12,480 * (1 - 0.09) = $11,368.80
Finally, we can calculate the incremental after-tax return on investment:
Incremental after-tax return on investment = After-tax profit / Incremental investment
Incremental after-tax return on investment = $7,677.60 / $11,368.80 = 0.6764 or 67.64%
c. To determine whether Collins should liberalize credit if a 15 percent after-tax return on investment is required, compare the incremental after-tax return on investment (67.64%) to the required rate of return (15%). Since the incremental after-tax return on investment is greater than the required rate of return, 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 consider both the increase in accounts receivable and the increase in inventory.
Incremental investment in accounts receivable = Increase in accounts receivable * (1 - accounts receivable uncollectible rate)
Incremental investment in accounts receivable = $12,480 * (1 - 0.09) = $11,368.80
Incremental investment in inventory = Increase in sales * (1 - inventory turnover)
Incremental investment in inventory = $80,000 * (1 - 4) = -$240,000 (negative since inventory turnover is four times)
Total incremental investment = Incremental investment in accounts receivable + Incremental investment in inventory
Total incremental investment = $11,368.80 + (-$240,000) = -$228,631.20
Therefore, the total incremental investment in accounts receivable and inventory to support an $80,000 increase in sales is -$228,631.20.
e. Based on the incremental after-tax return on investment calculated in part b (-$228,631.20) and the investment determined in part d ($7,677.60), Collins should carefully consider extending more liberal credit terms. The negative total incremental investment suggests that the additional investment required for the increase in sales may outweigh the after-tax profit generated.