Question

Henderson Office Supplies is considering a more liberal credit policy to increase sales, but it expects that 5 percent of the new accounts will be uncollectible. Collection costs are 5 percent of new sales, production costs are 80 percent of sales, and accounts receivable turnover is five times. Assume an increase in sales of $79,000. No other asset buildup will be required to service the new accounts.

a. What is the level of investment in accounts receivable to support this sales expansion? Investment in accounts receivable $

b. What would be Henderson’s incremental before‐tax return on investment? Return on incremental investment %

c. Should Henderson liberalize credit if a 35 percent before‐tax return is required (opportunity cost of capital)? Yes or No

Assume Henderson also needs to increase its level of inventory to support new sales and that inventory turnover is four times on Cost of Goods Sold. d. What would be the total incremental investment in accounts receivable and inventory to support a $79,000 increase in sales? Total incremental investment $

e. Given the income determined in part b and the investment determined in part d, should Henderson extend more liberal credit terms? Yes or No

Answer 1

a	Investment in accounts receivable =Increase in sale / account receivable turnover
	Investment in accounts receivable =$79,000 / 5times =$15,800
b	Increase in sales	$79,000
	Uncollectible receivable($79,000*5%)	(3,950)
	Annual Incremental Revenue	75,050
	Collection cost($79,000*5%)	(3,950)
	Production & Selling cost($79,000*80%)	(63,200)
	Incremental Revenue before tax	$7,900
	Return on Incremental Revenue($7,900 / 15,800)*100 =50.00%
c	Yes 50% exceeds the required return of 35%
d	Investment in inventory =$79,000 / 4=$19,750
	Total incremental investment.
	Inventory	$19,750
	Accounts Receivable	$15,800
	Incremental Investment	$35,550
e	No since the investment required in option D is more than which required in option b