Question

Dome Metals has credit sales of $432,000 yearly with credit terms of net 90 days, which is also the average collection period. Assume the firm adopts new credit terms of 2/15, net 90 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 11 percent. The new credit terms will increase sales by 10% because the 2% discount will make the firm's price competitive.

 

a. If Dome earns 15 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

Answer a.

New Sales = $432,000*1.10
New Sales = $475,200

Increase in Profit from new sales = Profit Margin * Increase in Sales
Increase in Profit from new sales = 15% * ($475,200 - $432,000)
Increase in Profit from new sales = $6,480

Average Accounts Receivable without discount = Average Collection Period * Average daily Sales
Average Accounts Receivable without discount = 90 * ($432,000/360)
Average Accounts Receivable without discount = 90 * $1,200
Average Accounts Receivable without discount = $108,000

Average Accounts Receivable with discount = Average Collection Period * Average daily Sales
Average Accounts Receivable with discount = 15 * ($475,200/360)
Average Accounts Receivable with discount = 15 * $1,320
Average Accounts Receivable with discount = $19,800

Reduction in Accounts Receivable = $108,000 - $19,800
Reduction in Accounts Receivable = $88,200

Reduction in accounts receivable will decrease the loan balance

Interest Saving = Interest Rate * Loan Reduction
Interest Saving = 11% * $88,200
Interest Saving = $9,702

Cost of Discount = Discount Rate * New Sales
Cost of Discount = 2% * $475,200
Cost of Discount = $9,504

Net Gain (loss) = Increase in Profit + Interest Saving - Cost of Discount
Net Gain (loss) = $6,480 + $9,702 - $9,504
Net Gain (loss) = $6,678

Answer b.

Yes, the firm should offer 2% discount as the firm realized net gain of $6,678