Question

Slow Roll Drum Co. is evaluating the extension of credit to a new group of customers. Although these customers will provide $234,000 in additional credit sales, 15 percent are likely to be uncollectible. The company will also incur $16,500 in additional collection expense. Production and marketing costs represent 70 percent of sales. The firm is in a 30 percent tax bracket. No other asset buildup will be required to service the new customers. The firm has a desired return of 10 percent. Assume the average collection period is 180 days. a. Compute the return on incremental investment. (Input your answer as a percent rounded to 2 decimal places. Use a 360-day year.) b. Should credit be extended to the new group of customers? Yes No

Answer 1

a) First, we have to compute the additional income after tax -

Particulars	Amount($)
Additional sales	234,000
Less: Uncollectible (15% x 234,000)	35,100
Less: Additional collection expense	16,500
Less: Production and marketing costs (70% x 234,000)	163,800
Additional income before tax	18,600
Less: Taxes @ 30%	5,580
Additional income after tax	13,020

Now, Average collection period = (Average receivables / credit sales) x 360

or, 180 = (average receivables / $234,000) x 360

or, Average receivables = $117,000

The above is the incremental investment (investment blocked in receivables).

Return on incremental investment = (Incremental income after tax / Incremental investment) x 100 = ($13,020 / $117,000) x 100 = 11.12821% or 11.13%

b) Yes, credit should be extended since return on incremental investment is more than the required return of 10%.