Question

Q58: Geoffrey’s Toy Box currently has sales of $1,000,000, and its days sales outstanding is 30 days. The new CFO estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2% on the old sales, would increase to 5 percent on the incremental sales while bad debts on the old sales would stay at 2 percent. Variable costs are 80 percent of sales, and Geoffrey’s Toy Box has a 15 percent receivables financing cost. Given corporate taxes of 21%, what would the annual incremental after-tax profit be if Geoffrey’s Toy Box extended its credit period?

Answer 1

Answer with working notes is given below

Current 30 days $1,000,000 $800,000 $200,000 Proposed 50 days $1,200,000 $960,000 $240,000 Sales Less: Variable cost Contribution Less Financing cost Bad debts-existing 2% on $1,000,000 incremental - $200,000 *5% Profit before tax Less: Taxes at 21% Profit after tax $10,000 $20,000 $20,000 WN below $20,000 $10,000 $190,000 $39,900 $150,100 $170,000 $35,700 $134,300 Annual incremental profit after tax L $15,800 ($150,100-$134,300) Working note : 30 days $83,333 50 days $166,667 Financing cost Days sales Outstanding Account Receivable (Sales X DSO)/360 days) Cost of AR-80% of above Financing cost $66,667 $10,000 $133,333 A $20,000 AX 15% Financing cost is calculated on Cost of Accounts Receivable Hence 80% of Accounts receivable is taken