You have been asked to assess the expected financial impact ofeach of the following proposals to improve the profitability ofcredit sales made by your company. Each proposal is independent ofthe other. Answer all questions. Showing your work may earn youpartial credit.
Proposal #1 would extend trade credit to some customersthat previously have been denied credit because they wereconsidered poor risks. Sales are projected to increaseby $200,000 per year if credit is extended to these new customers.Of the new accounts receivable generated, 7% are projected to beuncollectible. Additional collection costs are projected to be 3%of incremental sales (whether they actually end up collected ornot), and production and selling costs are projected to be 80% ofsales. Your firm expects to pay a total of 30% of its income afterexpenses in taxes.
- Compute the incremental income after taxes that wouldresult from these projections:
- Compute the incremental Return on Sales if these newcredit customers are accepted:
If the receivable turnoverratio is expected to be 4 to 1 and no other asset buildup is neededto serve the new customers…
- Compute the additional investment in AccountsReceivable
- Compute the incremental Return on NewInvestment
- If your company requires a 20% Rate of Return onInvestment for all proposals, do the numbers suggest that tradecredit should be extended to these new customers?Explain.
Proposal #2 would establish local collection centersthroughout the region to decrease the time it takes to convertcredit payments that are mailed in by check to cash. It isestimated that establishing these collection centers would reducethe average collection time by 2 days.
- If the company currently averages $60,000 incollections per day, how many dollars will this suggested cashmanagement system free up?
- If all freed up dollars would be used to pay down debtthat has an interest rate of 5%, how much money could be saved eachyear in interest expense?
- Do the numbers suggest that this new system should beimplemented if its total annual cost is $5200?Explain.
