Question

Dome Metals has credit sales of $126,000 yearly with credit terms of net 90 days, which is also the average collection period. Assume the firm adopts new credit terms of 4/18, 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 10 percent. The new credit terms will increase sales by 10% because the 4% discount will make the firm's price competitive. a. If Dome earns 30 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.) b. Should the firm offer the discount?

Answer 1

Answer:

a. Net gain of $693.

b. Yes; If the firm offers a 4 percent discount, it will realize a gain of $693.

Explanation:

a). New sales = 1.10 x $126,000 = $138,600

Increase in profit from new sales = Profit percent x Increase in sales

= 0.30 ×($138,600 - $126,000) = $3,780

Average accounts receivable balance without the discount

= Average collection period x Average daily sales = 90 x ($126,000 / 360) = $31,500

Average accounts receivable balance with the discount

= Average collection period x Average daily sales = 18 x ($138,600 / 360) = $6,930

Reduction in accounts receivable = $31,500 - $6,930 = $24,570

The $24,570 cash inflow from reducing accounts receivable will be used to reduce the firm's loan balance.

Interest savings = Interest rate x Loan reduction = 0.10 x $24,570 = $2,457

Cost of discount = Discount rate x Sales = 0.04 x $138,600 = $5,544

Net gain (loss) = Increase in profit + Interest savings - Cost of discount

= $3,780 + $2,457 - $5,544 = $693