Question

Dome Metals has credit sales of $270,000 yearly with credit terms of net 90 days, which is also the average collection period. Assume the firm adopts new credit terms of 2/15, net 90 and all customers pay on the last day of the discount period. Any reduction in accounts receivable will be used to reduce the firm's bank loan which costs 12 percent. The new credit terms will increase sales by 20% because the 2% discount will make the firm's price competitive.
a. If Dome earns 15 percent on sales before discounts, what will be the net change in income if the new credit terms are adopted? (Use a 360-day year.)

Answer 1

Answer:

Net change in income = $8,100

Explanation:

Given:

Current credit sales= $270,000 per year.

Average collection period= 90 days

A 2/15, net 90 means a 20℅ discount if payment is made within 15 days.

Which means new credit terms increase will be

(90/15) * 20℅ = 120℅

We now find the following:

•Revised sales will be = (current sales * new credit terms increase)

= $270,000 * 120℅ = $324,000

•Increase in sales = ( new sales - current sales)

=$324,000 - $270,000 = $54,000

•Profit increase = (profit percent * Increase in sales)

= 15℅ * $54,000 = $8,100

• Average receivable under existing policy =

= $270,000 * (90/360) = $67,500

• Average under new policy =

$325,000 * (15/360) = $13,500

• Receivable reduction= $67,500 - $13,500 = $54,000

• Interest savings

= $54,000 * 12℅ = $6,480

• Cost of discount =

$324,000 * 2℅ = $6,480

Therefore the net change in income if new credit terms are adopted will be = (increase in profit + interest savings - cost of discount)

= $8,100+$6,480-$6,480

= $8,100