Question

A firm is contemplating shortening its credit period from 40 to 30 days and believes that, as a result of this change, its average collection period will decline from 45 to 36 days. Bad-debt expenses are expected to decrease from 1.5% to 1% of sales. The firm is currently selling 12,000 units but believes that as a result of the proposed change, sales will decline to 10,000 units. The sale price per unit is $56, and the variable cost per unit is $45. The firm has a required return on equal-risk investments of 25%. Evaluate this decision, and make a recommendation to the firm. (Note: Assume a 360-day year.)

Answer 1

a	Chabge of profit because of decline in sale	$ (22,000)	-2000*(56-45)
b	Debtors before shortening credit period	$ 67,500	(12,000*45)*(45/360)
c	Debtors after shortening credit period	$ 45,000	(10,000*45)*(36/360)
d=b-c	Benefit from reduced collecction period:	$            5,625	(67,500-45,000)*25%
e	Bad debts post shortening	$            5,600	10,000*56*1%
f	Bad debts earlier	$ 10,080	12,000*56*1.5%
g=f-e	Savings as a result of reduced bad debts	$ 4480	10,080-5,600
h=a+d+g	Net financial impact	$ (11,895)

Since the net financial impact of the shortened credit limit is negative, it is not advisable to implement the idea.