Question 3 International Electric plc (IEP) has annual sales revenue of 365m, al

Question

Question 3 International Electric plc (IEP) has annual sales revenue of 365m, all of which is on credit terms and spread evenly throughout the year. IEP offers all customers 30 days credit, half of whom adhere to the terms, while the other half take an average of 70 days credit. This is of concern to IEP who have a bank overdraft of 60m @ 12% p.a. The business is therefore considering offering a 2% discount to all customers who adhere to the 30 days credit term. This is expected to result in half of those who pay in 70 days to pay in 30 days, but the balance to still take 70 days. But importantly, the scheme is expected to reduce bad debts by 300,000 per annum Required: Prepare an evaluation of the costs and benefits of the proposed scheme and advise IEP whether they should proceed with it or not.

Explanation / Answer

Note : what we have to take into account is the opportunity cost / saving of the above recommendations.

1. Cost of offering 2% discount ( to all customers who adhere to the 30 days credit period )

2. Expected saving / reduction in interest due to the offer

STATEMENT OF OPPORTUNITY COST / SAVING Euro millions Total sales revenue 365.0 Payment received in 30 days 182.5 Payment received in 70 days 182.5 If a discount is offered, collections are received in 30 days 182.5*50% 91.25 1. If discount is offered : cost of discount offered to all customers who pay in 30 days (182.50+91.25)*2% 5.475 Less : reduction in bad debts 0.03 Less : savings in interest on additional collections received in 30 days    (91.25 euro millions - restricted to 60 euro millions as OD is that amount only) 60*12%/12*40/30 0.8

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