Question

A company makes only cash sales (i.e., it has no receivables). It currently sells 1,000 units per month at a sales price of $45 and a present value of costs of $35 per unit. Firm plans to allow credit sales to increase its sales to 1,100 units per month, in which case all sales will be made on credit and 5% of sales will end up being uncollectible after the 30-day payment period. If the discount rate is 1% per month, should the firm extend the credit? Assume that under credit sale, production costs were paid at the time of sale and that outstanding receivables have an average of one month.

Answer 1

Solotion:

In the given case,benefit arises due to extending credit facility is;

Increase in sale(units)=1100 units-1000units=100units

Profit from additional sale=100*(45-35)=$1000

Cost of extending credit facility

Bad debts=(1100 units*5%)*35=$1925

Interest @1% on cash sales for 1month=(1000*10)*1%=$100

total cost=$2025

Since the total cost of extending credit facility is higher than the profit from addiyonal sales,hence it is advisable not to extend the credit.