Question

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 8 percent of the new accounts will be uncollectible. Collection costs are 2 percent of new sales, production and selling costs are 74 percent, and the accounts receivable turnover is two times. Assume income taxes of 35 percent and an increase in sales of $76,000. No other asset buildup will be required to service the new accounts.  

a. What additional investment in accounts receivable is needed to support this sales expansion?
  

   

b. What would be Henderson’s incremental aftertax return on investment? (Input your answer as a percent rounded to 2 decimal places.)
  

   

c. Should Henderson liberalize credit if a 15 percent aftertax return on investment is required?
  

	Yes
	No

  

Assume that Henderson also needs to increase its level of inventory to support new sales and that the inventory turnover is four times.  

d. What would be the total incremental investment in accounts receivable and inventory needed to support a $76,000 increase in sales?
  

   

Answer 1

Solution:

a. Additional investment in account receivable = Incremental accounts receivable

= Incremental sales / Accounts receivable turnover

= $76,000 / 2 = $38,000

b. Incremental after tax return on investment = Incremental income(see workings) / Incremental accounts receivable

   = $7,904 / 38,000

= 20.8%

c. Yes! Because Incremental after tax return on investment i.e.20.8% is greater than required rate of return i.e.15%.

d. Total incremental investment = Incremental accounts rec + Incremental inventory

   = $38,000 + $76,000/4

   = $57,000

Workings:

Incremental income = Sales{1-(production cost % + collection cost %+ Bad debts %)} (1-Tax %)

   = $76,000{1-(0.74+0.02 + 0.08)}(1-0.35) = $7,904