Tara\'s Textiles currently has credit sales of $361 million per year and an aver

Question

Tara's Textiles currently has credit sales of $361 million per year and an average collection period of 63 days. Assume that the price of Tara's products is $61 per unit and that the variable costs are $55 per unit. The firm is considering an accounts receivable change that will result in a 20.4% increase in sales and a 19.5% increase in the average collection period. No change in bad debts is expected. The firm's equal-risk opportunity cost on its investment in accounts receivable is 13.2%. (Note: Use a 365-day year.)

a. Calculate the additional profit contribution from sales that the firm will realize if it makes the proposed change. (I calculated a. as $7,243,672)

b. What marginal investment in accounts receivable will result?

c. Calculate the cost of the marginal investment in accounts receivable.

d. Should the firm implement the proposed change? What other information would be helpful in your analysis?

Explanation / Answer

a) Current units = $361,000,000/$61 = 5,918,033 units

Increase = 5,918,033 x 20.4% = 1,207,279 new units

Additional profit contribution = ($61 - $55) x 1,207,279 units                                                                 = $7,243,672.13

b) Average investment in accounts receivable=

Turnover, present plan                                             =

Turnover, proposed plan                                         =

Marginal Investment in A/R:

Average investment, proposed plan:

=          $81,644,193.99

Average investment, present plan:

                                         =       $56,804,852.23

Marginal investment in A/R                                   =          $24,839,341.76

*Total units, proposed plan = existing sales of 5,918,033 units + 1,207,279 additional units.

c) Cost of marginal investment in accounts receivable:

Marginal investment in A/R                             $24,839,341.76

Required return                                                                                      x .13

Cost of marginal investment in A/R                                  $ 3,229,114.43

d) The additional profitability of $7,243,672.13 exceeds the additional costs of $3,229,114.43

therefore the proposed change should be adopted, yet one would need estimates of

bad debt expenses, clerical costs, and some information about the uncertainty of the

sales forecast prior to adoption of the policy.

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