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 7 percent of the new accounts will be uncollectible. Collection costs are 2 percent of new sales, production and selling costs are 79 percent, and the accounts receivable turnover is two times. Assume income taxes of 30 percent and an increase in sales of $81,000. No other asset buildup will be required to service the new accounts.

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

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

c. Should Henderson liberalize credit if a 14 percent aftertax return on investment is required? Yes or No

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

d. What would be the total incremental investment in accounts receivable and inventory needed to support a $81,000 increase in sales?

Explanation / Answer

Given data can be summarized as follows:

Additional sales = $81000

Accounts uncollectible = 7% (Additional sales) = 7%($81000) = $5670

Additional collection costs = 2% (Sales) = 2%($81000) = $1620

Production and selling costs = 79%(Additional sales) = $63990

Receivables Turnover ratio = 2 times

Tax rate = 30%

(a) We know,

Accounts receivable = Sales/Turnover ratio = $81000/2 =$40500

(b) Annual income before taxes = $81000 - $5670 -$1620 -$63990 =$9720

Taxes = 30%($9720) = $2916

Annual Incremental income after taxes = $9720 - $2916 = $6804

Incremental income/Accounts receivables = $6804/$40500 = 16.8%

(c) Since incremental after tax return (16.8%) is greater than the required 14%, liberalized credit policy is acceptable.

(d) From inventory turnover ratio:

inventory = total productio and selling cost/inventory turnover = $63990/5 = $12798

Total incremental investment = inventory + receivables = $12798 + $40500 = $53298

DO THUMBS UP ^_^

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