Question

Tightening Credit Terms Kim Mitchell, the new credit manager of the Vinson Corporation, was alarmed to find that Vinson sells on credit terms of net 90 days while industry-wide credit terms have recently been lowered to net 30 days. On annual credit sales of $2.83 million, Vinson currently averages 95 days of sales in accounts receivable. Mitchell estimates that tightening the credit terms to 30 days would reduce annual sales to $2,705,000, but accounts receivable would drop to 35 days of sales and the savings on investment in them should more than overcome any loss in profit. Vinson’s variable cost ratio is 72%, taxes are 40%, and the interest rate on funds invested in receivables is 20%. Assuming a 365-day year, calculate the cost of carrying receivables under the current policy and the new policy. Enter your answers as positive values. Do not round intermediate calculations. Round your answers to the nearest dollar. Current policy: $ New policy: $ Should the change in credit terms be made? -Select-

Answer 1

Answer:

first we must determine the average accounts receivable under the current policy:

($2,830,000 x 90 days) / 365 days = $697,808.22

carrying cost of current accounts receivable = $697,808.22 x 20% x  90/365 = $34,412.46

net after tax cost of current policy = $34,412.46 x (1 - 40%) = $20,647.48

average accounts receivable under the new policy:

($2,705,000 x 35 days) / 365 days = $259,383.56

carrying cost of new accounts receivable = $259,383.56 x 20% x  35/365 = $4,974.48

net after tax cost of new policy = $4,974.48 x (1 - 40%) = $2,984.69

net savings from new policy = $20,647.48 - $2,984.69 = $17,662.79

but the company will lose profits due to a decrease in total sales:

lost revenues = ($2,830,000 - $2,705,000) x (1 - 72%) x (1 - 40%) = $21,000

advantage/disadvantage of new policy = net savings - lost profits = $17,662.79 - $21,000 = -$3,337.21

Since the new policy decreases profits by $3,337.21, it should be rejected.