Henderson Office Supply is considering a more liberal credit policy to increase

Question

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 6 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 78 percent, and the accounts receivable turnover is four times. Assume income taxes of 25 percent and an increase in sales of $80,000. No other asset buildup will be required to service the new accounts.

What additional investment in accounts receivable is needed to support this sales expansion?

What would be Henderson’s incremental aftertax return on investment? (Input your answer as a percent rounded to 2 decimal places.)

Should Henderson liberalize credit if a 16 percent aftertax return on investment is required?

Assume that Henderson also needs to increase its level of inventory to support new sales and that the inventory turnover is four times.

What would be the total incremental investment in accounts receivable and inventory needed to support a $80,000 increase in sales?

Given the income determined in part b and the investment determined in part d, should Henderson extend more liberal credit terms?

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 6 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 78 percent, and the accounts receivable turnover is four times. Assume income taxes of 25 percent and an increase in sales of $80,000. No other asset buildup will be required to service the new accounts.

Explanation / Answer

(a)

Increase in sales = $80,000

Accounts receivable turnover = 4

Additional investment in Accounts Receivable needed

= Incease in sales / Accounts Receivable Turnover

= $80,000 / 4

= $20,000

(b)

Increase in sales = $80,000

Uncollectible accounts = 6% of sales = $80,000 x 6% = $4,800

Collection costs = 6% of sales = $80,000 x 6% = $4,800

Production and selling costs = 78% of sales = $80,000 x 78% = $62,400

Therefore,

Incremental income = $80,000 - $4,800 - $4,800 - $62,400 = $8,000

Tax = 25% of income = $8,000 x 25% = $2,000

Thus,

Incremental income after taxes = $8,000 - $2,000 = $6,000

And,

Incremental investment = $20,000 (computed in part a)

Therefore,

Return on incremental investment = $6,000 / $20,000 = 30%

(c)

Since the return on incremental investment is higher than the required rate of return, the should liberalize credit.

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