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Proposal #1 would extend trade credit to some customers that previously have been denied credit because...

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Proposal #1 would extend trade credit to some customersthat previously have been denied credit because they wereconsidered poor risks.   Sales are projected to increaseby $150,000 per year if credit is extended to these new customers.Of the new accounts receivable generated, 7% are projected to beuncollectible. Additional collection costs are projected to be 3%of incremental sales (whether they actually end up collected ornot), and production and selling costs are projected to be 80% ofsales. Your firm expects to pay a total of 40% of its income afterexpenses in taxes.

1)Compute the incremental income aftertaxes that would result from these projections:

2)Compute the incremental Return onSales if these new credit customers are accepted:

If the receivable turnover ratio is expected to be 3 to1 and no other asset buildup is needed to serve the newcustomers…

3)Compute the additional investment inAccounts Receivable

4)Compute the incremental Return on NewInvestment

5)If your company requires a 20% Rateof Return on Investment for all proposals, do the numbers suggestthat trade credit should be extended to these new customers?Explain.

Answer & Explanation Solved by verified expert
3.8 Ratings (649 Votes)

A Increase in sales $150,000
B=0.07*A Amount expected to be Uncollectable $10,500
C=0.03*A Additional collection cost $4,500
D=A-B-C Net Increase in sales Revenue $135,000
E=0.8*A Increase in production and selling cost $120,000
F=D-E Increase in before tax income $15,000
G=0.4*F Tax expense $6,000
1) H=F-G Incremental income after taxes $9,000
2) I=H/A IncrementalReturn on Sales 0.06
IncrementalReturn on Sales(percentage) 6%
J Receivable turnover Ratio 3
Receivable turnover Ratio=Sales/Accounts Receivable
3) K=A/J Additional investment in Accounts receivable $50,000
4) L=H/K Incremental return on new investment 0.18
Incremental return on new investment(Percentage) 18%
5) Trade should not be extended to these new customers
Because return on investment is less than required return of 20%

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