Question

Dome Metals has credit sales of $414,000 yearly with credit terms of net 60 days, which is also the average collection period. Assume the firm adopts new credit terms of 4/10, net 60 and all customers pay on the last day of the discount period. Any reduction in accounts receivable will be used to reduce the firm's bank loan which costs 10 percent. The new credit terms will increase sales by 20% because the 4% discount will make the firm's price competitive.

a. If Dome earns 25 percent on sales before discounts, what will be the net change in income if the new credit terms are adopted? (Use a 360-day year.)

Answer 1

New sales= 1.20 ×$414,000= $496,800

Increase in profit from new sales= Profit percent ×Increase in sales

= .25 ×($496,800 – 414,000)= $20,700

Average accounts receivable balance without the discount= Average collection period ×Average daily sales= 60 ×($414,000 / 360)= $69,000

Average accounts receivable balance with the discount= Average collection period ×Average daily sales= 10 ×( $496,800 / 360)= $13,800

Reduction in accounts receivable= $69,000 – 13,800= $55,200

The $55,200 cash inflow from reducing accounts receivable will be used to reduce the firm's loan balance.

Interest savings= Interest rate ×Loan reduction

= .10 ×$55,200= $5,520

Cost of discount= Discount rate ×Sales

= .04 ×$496,800= $19,872

Net gain (loss)= Increase in profit + Interest savings – Cost of discount

= $20,700 + 5,520 – 19,872= $6,348

If the firm offers a 4% discount, it will realize a gain of $6,348.