Question

Johnson Electronics is considering extending trade credit to some customers previously considered poor risks. Sales would increase by $125,000 if credit is extended to these new customers. Of the new accounts receivable generated, 8 percent will prove to be uncollectible. Additional collection costs will be 3 percent of sales, and production and selling costs will be 80 percent of sales. The firm is in the 30 percent tax bracket.  

a. Compute the incremental income after taxes.
  

   

b. What will Johnson’s incremental return on sales be if these new credit customers are accepted? (Input your answer as a percent rounded to 2 decimal places.)
  

c. If the accounts receivable turnover ratio is 6 to 1, and no other asset buildup is needed to serve the new customers, what will Johnson’s incremental return on new average investment be? (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

Answer 1

A)

Additional sales	$125000
Less: uncollectible receivable ($125000×8%)	($10000)
Annual incremental revenue	$115000
Less: collection cost (3% × $125000)	($3750)
Less: production and selling cost (80% × $125000)	($100000)
Annual income before taxes	$11250
Taxes @ 30%	($3375)
Incremental income after tax	$7875

B)

Incremental Return on Sales = Incremental Income/Incremental Sales

= $7875/$125000 = 6.3%

C)

Receivable = Sales/Receivables Turnover = $125000/6 = $20833.33

Incremental Return on New Average Investment = Incremental Income/Receivables = $7875/20833.33 = 37.8%

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