Winslow, Inc., a battery manufacturer, is contemplating lengthening its credit p

Question

Winslow, Inc., a battery manufacturer, is contemplating lengthening its credit period from net 30 days to net 60 days. Presently, its average collection period is 40 days, and the firm’s CFO believes that with the proposed new credit period, the average collection period will be 75 days.  The firm’s sales are $800 million, and the CFO believes that with the new credit terms, sales will increase to $900 million.  At the current $800 million sales level, the firm’s variable costs are $560 million.  The firm’s CFO estimates that with the proposed new credit terms, total bad debt expenses will increase from the current level of 1.5 percent of sales to 3.0 percent of sales.  The CFO also estimates that due to the increased sales volume and accompanying receivables, the firm will have to add additional facilities and personnel to its credit and collections department.  The annual cost of the expanded credit operations resulting from the proposed new credit period is estimated to be $12 million.  The firm’s required return on similar risk investments is 15 percent. Assume a 365-day year.  Evaluate the economics of Winslow’s proposed credit-period lengthening, and make a recommendation to the firm’s management, as to whether or not the new credit policy should be implemented.

Explanation / Answer

The result of the change will be as below:

Increase in sales = (900-800) = $ 100 million

Increase in variable costs = (560/800)*900-560 = $ 63 million

Increase in collection period = 35 days

Increase in bad debt = (3%* 900) - (1.5% * 800) = $ 15 million

Increased cost of credit operations = $ 12 million

Now average collection period is given by : Accounts Receivable / Average daily sales. Since we are given average collection period will become 75 from 40, we will calculate the accounts receivables at both these level to guage the increase in the working capital required due to this change:

Original collection period : 40 = Accounts Receivable / (800/365) or Accounts Receivable of $ 87.67

Increased collection period : 75 = Accounts Receivable / (900/365) or Accounts Receivable of $ 184.93.

Taking the accounts receivable as proxy for the average accounts receivables from credit sales, we see that the working capital requirement will increase by (184.93-87.67) = $ 97.26 million

Now we can calculate the net benefit of this entire exercise:

(100-63-15-12) = $ 10 million

Now we will consider impact of increased working capital which will be $ 97.26 million and at required rate of return of 15%, the opportunity cost will be $ 14.59 million.

Atfer considering the opportunity cost of increased working capital , the net benefit will be negative hence the company should not pursue this strategy.

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