Question

Scott's sister, Amy, owns a very large pet supply business in Wisconsin. Last year she sold $30,000,000 worth of product to her wholesalers "net 30". Scott recently reviewed the financials of her company and determined that their average collection period is 48 days. Amy was not happy with this number, as her cash flow is becoming tight and difficult to deal with due to customers taking too long to pay. Scott mentioned that she should consider offering a cash discount for those customers who pay much more quickly--perhaps a 2% cash discount for those who pay in full within ten days. After some consideration, Amy decided to move forward with it; expecting that roughly 50% of her customers will take advantage of the discount. If all goes well, the average collection period should decline by 18 days. The opportunity cost on the receivables investment is 16%. Determine the cost to Amy.

Answer 1

Proposal 1: Existing Policy

Proposal 2: New Policy i.e. 2% discount if payment made in 10days

Analysis

Particulars	Proposal 1	Proposal 2
Avg Collection Period	48 days	18 days
Discount (W.N 1)	Nil	300000
Cost of Funding (W.N.2)	631232.8767	236712.3288
Total Cost	631232.8767	536712.3288

Proposal 2 must be selected because there is a savings of $ 94521 (631232.8767-536712.3288).

W.N.1: Calculation of Discount

In Proposal 1 - No discount is given in this proposal. So it is nil.

Proposal 2- $30000000 X 50%X 2% = 300000

W.N.2: Cost of Funding

Proposal 1

Sales x ACP x opportunity cost

= 30000000 x (48/365) x 0.16

= 631232.8767

Proposal 2

= 30000000 x (18/365) x 0.16

= 236712.3288