Question

Question: Question:Proposal #1 would extend trade credit to some customers that previously have been denied credit because they were considered poor risks. Sales are projected to increase by $120,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 6% are projected to be uncollectible. Additional collection costs are projected to be 5% of incremental sales, and production and selling costs are projected to be 80% of sales. Your firm expects to pay a total of 30% of its income after expenses in taxes.

1) Compute the incremental income after taxes that would result from these projections:

2) Compute the incremental Return on Sales if these new credit customers are accepted: If the receivable turnover ratio is expected to be 4 to 1 and no other asset buildup is needed to serve the new customers...

3) Compute the additional investment in Accounts Receivable

4) Compute the incremental Return on New Investment

5) If your company requires a 20% Rate of Return on Investment for all proposals, do the numbers suggest that trade credit should be extended to these new customers? Explain.

Proposal #2 would establish local collection centers throughout the region to decrease the time it takes to convert credit payments that are mailed in by check to cash. It is estimated that establishing these collection centers would reduce the average collection time by 2 days.

1) If the company currently averages $25,000 in collections per day, how many dollars will this suggested cash management system frees up?

2) If all freed up dollars would be used to pay down debt that has an interest rate of 8%, how much money could be saved each year in interest expense?

3) Do the numbers suggest that this new system should be implemented if its total annual cost is $7200? Explain.

Answer 1

Proposal 1:

2. Return on sales = (Income after tax / Sales )* 100 = (7560/ 120000)* 100 = 6.3%

3. Additional investment in accounts receivable = Sales / Accounts receivable ratio= $120,000 / 4= $30,000

4. Incremental return = Income after tax / Additional investment in accounts receivable = 7560/30,000 =25.2%

5. The proposal should be accepted since the incremental return is higher the expected return of 20%.

Proposal 2:

1. Cash management system free up = 25,000 * 2 = 50,000

2. Money that can be saved = 25000 * 2* 365 * (8% /365) = $4000

3. It should not be accepted since the money saved is lesser than the annual cost incurred on the proposal.