Q32. Simpson Enterprises is considering relaxing its credit standards in order t

Question

Q32. Simpson Enterprises is considering relaxing its credit standards in order to increase its currently sagging sales. As a result of the proposed relaxation, sales are expected to increase by 20% from 10,000 units to 12,000 units during the coming year; the average collection period is expected to increase from 45 days to 60 days; and bad debts are expected to increase from 1% to 2% of sales. The sale price per unit is $39 and the variable cost per unit is $30. If the firm’s required return on equal-risk investments is 20%, evaluate the proposed relaxation and make a recommendation to the firm. (Use a 360-day year for your calculations.)

Explanation / Answer

Additional profit contribution from sales = 1,000 additional units ´ ($39 - $30) = $9,000

Cost of marginal investment in A/R:

Average investment, proposed plan =(12000units* $30) / (360/60) = $60000

Average investment, present plan = (10000units* $30) / (360/45) = $37500

Marginal investment in A/R ( $60000 - $37500 ) = $22500

Required return on investment ($22500*0.2)   

Cost of marginal investment in A/R = (4500)

Cost of marginal bad debts:

Bad debts, proposed plan (0.02 * $39 * 12,000 units) = $9360

Bad debts, present plan (0.01 * $39 * 10,000 units) = $3900

Cost of marginal bad debts = ($5460)

Net loss from implementing proposed plan = ($960)

The credit standards should not be relaxed since the proposed plan results in a loss.

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