Lewis Enterprises is considering relaxing its credit standards to increase its c

Question

Lewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a result of the proposed relaxation, sales are expected to increase by 15% from 12,000 to 13,800 units during the coming year; the average collection period is expected to increase from 35 to 55 days; and bad debts are expected to increase from 3% to 5% of sales. The sale price per unit is $36, and the variable cost per unit is $24. The firms required return on equal-risk investments is 24.9%. Evaluate the proposed relaxation, and make a recommendation to the firm. (Note: Assume a 365-day year.

The additional profit contribution from an increase in sales is $___.

The cost from the increased marginal investment in A/R is $___.

The cost from the increase in bad debts is $___.

The net profit or loss from implementing the proposed plan is $___.

Is this proposed plan recomended? Yes or No

Explanation / Answer

Lewis Enterprises All Amounts in $ Original Profits from sale of 12,000 units = 12,000 X ($36 - $24) = 12,000 X $ 12 = $ 144,000. Revised Profits from sale of 13,800 units = 13,800 X ($36 - $24) = 13,800 X $ 12 = $ 165,600. Thus, the additional profit contribution from an increase in sales is $ 21,600 ($ 165,600 - $ 144,000) Average Collection Period = 365 / (Net Sales / Accounts Receivables) For the original sales, the collection period is 35 days Hence, the Accounts Receivables will be 35 X $ 144,000 / 365 = 13808 $ For the revised sales, the collection period is 55 days Hence, the revised Accounts Receivables will be 55 X $ 165,600 / 365 = 24953 $ Thus, the additional investment in Accounts Receivables will be $ 11,145 ($ 24,953 - $ 13,808). The cost of this additional investment will be 24% of $ 11,145 = 2675 $ The original bad debts will be 3% of sales, which is 3% of $ 144,000 = $ 4,320 The revised bad debts will be 5% of sales, which is 5% of $ 165,600 = $ 8,280 The cost of the increase in bad debts will be $ 3,960 ($ 8,280 - $ 4,320) The net profit or loss from implementing the new plan will be $ 21,600 - $ 2,675 - $ 4,320 = 14605 $ Hence, the proposed plan is recommended, since it results in an additional net profit of $ 14,605.

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