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 9 percent of the new accounts will be uncollectible. Collection costs are 3 percent of new sales, production and selling costs are 72 percent, and the accounts receivable turnover is four times. Assume income taxes of 25 percent and an increase in sales of $77,000. 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 20 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 $77,000 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 9 percent of the new accounts will be uncollectible. Collection costs are 3 percent of new sales, production and selling costs are 72 percent, and the accounts receivable turnover is four times. Assume income taxes of 25 percent and an increase in sales of $77,000. No other asset buildup will be required to service the new accounts.

Explanation / Answer

a) Level of Accounts Receivable = (Increase in sales) / (Accounts receivable turnover) = $77000 / 4 times = $19250

Therefore the amount of accounts receivable to support this sales expansion is $19250.

b) Added sales = $77,000

Accounts uncollectible (9% of new sales) = $6930

Annual incremental revenue = Added Sales - Accounts uncollectible = 77000 - 6930 = $70070

Collection costs (3% of new sales) = $2,310

Production and selling costs (72%) = $55440

Annual income before taxes = Annual incremental revenue - Collection costs - Production and selling costs = 70070 - 2,310 - 55440 = $12320

Taxes (25%) = $3080

Incremental income after taxes = Annual income before taxes - Taxes = 12320 - 3080 = $9240

Incremental after tax return on investment = (Incremental income after taxes) / (Level of accounts receivable) = $9240 / $19250 = 0.48

Hence the Incremental after tax return on investment is 48%

c) Yes 48% exceeds the required return of 20%.

d) Investment in Inventory = (Increase in sales) / (Inventory turnover) = $77000 / 4 times = $19250

Total Increment investment = Investment in Inventory + Level of accounts receivable = $19250 + $19250 = $38500

e) Return of Investment = (Increment Income after taxes) / (Increment Investment) = $9240 / $38500 = 24%

No.

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