Question

Kari-Kidd Corporation currently gives credit terms of "net 45 days." It has $45 million in credit sales, and its average collection period is 50 days. To stimulate demand, the company may give credit terms of "net 70 days." If it does instigate these terms, sales are expected to increase by 25 percent. After the change, the average collection period is expected to be 80 days, with no difference in payment habits between old and new customers. Variable costs are $8 for every $12 of sales, and the company's before-tax required rate of return on investment in receivables is 30 percent.

(A)Should the company extend its credit period? (Assume a 360-day year.)

Answer 1

Kari-Kidd Corporation has a required rate of return on receivables of 30%.

As per the question, Kari-Kidd Corporation has an option between 2 credit policies which are as follows :-

1. Current Credit Policy - Net 45 days

Credit Sales = $ 45 million

Average Collection Period = 50 days.

Variable Cost is $8 for every $12 of Sales.

Variable Cost = Sales /12 * 8

                      = 45 million / 12*8

Variable Cost = $ 30 million

Required Return will be calculated on Variable costs and not Sales as the company has incurred only the cost and not total sales amount.

Required Return = 30% of Variable Cost for Average collection period

                            = 30% * 30 million * 50/360

Required Return = $ 1,250,000.

Thus, Profit after deducting required return = Sales - Variable Cost - Required Return

Profit after deducting required return = 45,000,000 - 30,000,000 - 1,250,000

Profit after deducting required return = $ 13,750,000.

2. Proposed Credit Policy - Net 70 days

Credit Sales = Original Sales + ( 25% of Original Sales)

                    = 45 million + ( 25% * 45 million)

Credit Sales = $ 56.25 million

Average Collection Period = 80 days

Variable Cost = Sales /12 * 8

                      = 56.25 million /12*8

Variable Cost = $ 37.50 million

Required Return = 30% of Variable Cost for Average collection period

                           = 30% * 37.50 million * 80/360

Required Return = $ 2,500,000.

Thus, Profit after deducting required return = Sales - Variable Cost - Required Return

Profit after deducting required return = 56,250,000 - 37,500,000 - 2,500,000

Profit after deducting required return = $ 16,250,000.

Thus, net profit after deducting required return on receivables for Credit of net 45 days is $ 13.75 million and for credit of net 70 days is $ 16.25 million.

Thus, the profit will increase if the credit period is increased from net 45 days to net 70 days.

Thus, the company should extend its credit period.