Question

Dome Metals has credit sales of $288,000 yearly with credit terms of net 120 days, which is also the average collection period. Assume the firm adopts new credit terms of 3/18, net 120 and all customers pay on the last day of the discount period. Any reduction in accounts receivable will be used to reduce the firm's bank loan which costs 10 percent. The new credit terms will increase sales by 15% because the 3% discount will make the firm's price competitive.
   
a. If Dome earns 20 percent on sales before discounts, what will be the net change in income if the new credit terms are adopted? (Use a 360-day year.)
  

   

b. Should the firm offer the discount?
  

Answer 1

New sales = 1.15 × $288,000 =  $331,200

Increase in profit from new sales = Profit percent × Increase in sales=  0.20 × (331200 – 288,000)= = $8,640

Average accounts receivable balance without the discount= Average collection period × Average daily sales

= 120 × ($288,000 / 360)= $96,000

Average accounts receivable balance with the discount= Average collection period × Average daily sales

=18 × ( $331,200 / 360)= $16,560

Reduction in accounts receivable = $96,000 – 16,560 = $79,440

The $79,440 cash inflow from reducing accounts receivable may be used to reduce the firm's loan balance

Interest Savings = 79440 * 0.10 = $ 7944

Cost of Discount = 331200 * 0.03 = $ 9936

a) Net Gain = Increase in Net Profit +Interest Savings - Cost of Discount= 8640 + 7944 - 9936 = $6648

b) Yes the firm should offer discount as the firm is earning additional Net Income of $6648.