Question

BUSI 320 Comprehensive Problem 2 FALL 2020 You have been asked to assess the expected financial impact of each of the following proposals to improve the profitability of credit sales made by your company. Each proposal is independent of the other. Answer all questions. Showing your work may earn you partial credit. Proposal #1 would extend trade credit to some customers that previously have been denied credit because they were considered poor risks. Sales are projected to increase by $240,000 per year if credit is extended to these new customers. Of the new accounts receivable generated, 6% are projected to be uncollectible. Additional collection costs are projected to be 2% of incremental sales (whether they actually end up collected or not), and production and selling costs are projected to be 78% of sales. Your firm expects to pay a total of 30% of its income after expenses in taxes. 1) Compute the incremental income after taxes that would result from these projections: 2) Compute the incremental Return on Sales if these new credit customers are accepted: If the receivable turnover ratio is expected to be 3 to 1 and no other asset buildup is needed to serve the new customers... 3) Compute the additional investment in Accounts Receivable 4) Compute the incremental Return on New Investment 5) If your company requires a 20% Rate of Return on Investment for all proposals, do the numbers suggest that trade credit should be extended to these new customers? Explain. Proposal #2 would establish local collection centers throughout the region to decrease the time it takes to convert credit payments that are mailed in by check to cash. It is estimated that establishing these collection centers would reduce the average collection time by 2 days. 1) If the company currently averages $50,000 in collections per day, how many dollars will this surested cash management system free up? o

Answer 1

In the first part of the problem company wants to extend credit sale facility to some new custoners. Results of this proposal are as follows:

1. Sales will increase by $240,000

2. 6% of this sale is uncollectible. So bad debt is $240,000 x 6% = $14,400

3. Incremental Collection cost is 3% of additional sale. So collection cost is $24,0000 x 2% = $ 4,800

4. Production and sales cost is 78% of incremental sale. Hence costs are:

$240,000 x 78% = $187200

Considering above information, incremental income/ loss has been calculated. It is shown in the table below:

Descriptions	amount
1. Incremental sales	$240,000
2. Production and sales cost	$187200
3. Collection cost	$4800
4. Uncollectibles	$14400
5. Incremental profit before tax [1-2-3-4]	$33600
6. Tax 30% on [1-2-3] ($48000 X 30%)	$14,400
7. Net incremental income after tax [ 5 - 6 ]	$19200

Note: Uncollectble is a loss which is directly attributable to errors in selecting customer for credit offer. So it is not deducted for computing taxable income. Before its deduction, you have to pay tax.

Answer 1: Incremental income after tax is $19200

Answer 2: Incremental return on sales is:[$19200/$240,000] * 100 = 8%

Answer 3: Receivable turnover is a ratio indicating number of times sales figure in comparison with receivables. It is calculated by using the following formula

$\text{Sales turnover}=\frac{\textup{Sales revenue}}{\textup{Receivables}}$

Here this ratio is 3 to 1. Therefore,

$\text{Sales turnover}=\frac{\textup{Sales revenue}}{\textup{Receivables}}=3$

Substitute sales revenue $240,000 in the above formula:

240,000    = 3

Receivables

Receivables=$240000 = $80000

3

Therefore additional investment in receivable is $80000

Answer 4: Incremental return on new investment is:

$19200 * 100 = 24%

$80000

Answer 5: If company requires 20% return on new investment, then this proposal should be accepted. as it has return higher than required rate.

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Answer of Proposal 2:

This propsal is related with cash management. Company at present taking considerable time in collecting and depositing cash from customers. It has decided to arrange a lock box system. It will reduce 2 collection days. In each day average collection is $50,000. Thus this propsal will free 2 days collection. The amount is:

$50,000 x 2 = $100,000

In a year interest rate paid on debt is 6%. This free cash will be available throughout the year. It is a continuous process. Hence money that it will save is 6% on $100,000 = $6,000.

If the annual cost of implementing the system is $8,000, then this new proposal is rejected. The proposal will not provide more tax savings than its cost