In an effort to speed up the collection of receivables, Hill Publishing Company

Question

In an effort to speed up the collection of receivables, Hill Publishing Company is con-sidering increasing the size of its cash discount by changing its credit terms from "1/ 10, net 30" to "2/ 10, net 30" Currently, the companys collection period averages 43 days. Under the new credit terms, it is expected to decline to 28 days. Also, the percentage of customers who will take advantage of the cash discount is expected to increase from the current 50 percent to 70 percent with the new credit terms. Bad-debt losses currently average 4 percent of sales and are not expected to change signifi-cantly if Hill changes its credit policy. Annual credit sales are $ 3.5 million, the variable cost ratio is 60 percent, and the required pretax rate of return ( i. e., the opportunity cost) on receivables investment is 14 percent. The company does not expect its inven-tory level to change as a result of its proposed change in credit terms. Assuming that Hill does decide to increase the size of its cash discount, determine the following: a. The earnings on the funds released by the change in credit terms b. The cost of the additional cash discounts taken c. The net effect on Hills pretax profits

Explanation / Answer

A.- EXTRA FUND RELEASED BY INTRODUCING NEW CREDIT TERM-

AVERAGE RECIVABLE ON OLD CREDIT TERM= ANNUAL CREDIT SALES*43DAYS/365DAYS

=$3.5 MILLION*43/365

=$0.41 MILLION

AVERAGE RECIVABLE ON NEW CREDIT TERM= ANNUAL CREDIT SALES*43DAYS/365DAYS

=$3.5 MILLION*28/365

=$0.27 MILLION

TOTAL DECREASE IN THE RECIVABLE= $0.41 - $0.27

=$0.14 MILLION

EARNING ON THE EXTRA FUND RELEASED= REQUIRED PRETAX RETURN* EXTRA FUND RELEASED

=14%*$0.14

=$0.0196 MILLION

B.- DISCOUNT COST ON OLD CREDIT TERM= SALES*%OF CUSTOMER TAKING ADVANTAGE*1%

= $3.5 MILLION * 50% * 1%

=$0.0175

DISCOUNT COST ON NEW CREDIT TERM= SALES*%OF CUSTOMER TAKING ADVANTAGE*1%

= $3.5 MILLION * 70% * 2%

=$0.049 MILLION

EXTRA DISCOUNT COST ON NEW CREDIT TERM= $0.0175 - $0.049

=$0.0315 MILLION

C.- NET EFFECT ON PRETAX PROFIT

PRETAX PROFIT= ANNUAL SALES * PROFIT VALUME RATIO(SALES RATIO - VARIABLE COST RATIO)

=$3.5 MILLION * 40%(100% - 60%)

=$1.4 MILLION

PRETAX PROFIT = $1.4MILLION

ADD- EARNING ON THE EXTRA FUND RELEASED =$0.0196 MILLION

LESS-EXTRA DISCOUNT COST ON NEW CREDIT TERM =$0.0315 MILLION

TOTAL EFFECT =$1.3881 MILLION

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