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Chapter 3: 18BP_e (page 223)

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 74 percent, and accounts receivable turnover is four times. Assume income taxes of 20 percent and an increase in sales of $65,000. No other asset build-up will be required to service the new accounts.

e. Given the income determined in part b and the investment determined in part d, should Henderson extend more liberal credit terms?

Short Answer

Expert verified

The company should not liberalize its credit policy.

Step by step solution

01

Calculation of incremental after-tax return on investment

The incremental after-tax return on investment is 11.74%.

Incrementalafter-taxreturnoninvestment=IncrementalincomeTotalincrementalinvestment脳100=$5,720$48,750脳100=11.74%

02

Credit policy should not be liberalized

The required rate of incremental return is 16% but the company has an incremental after-tax return on investment of 11.74%, so the company should not liberalize its credit policy. The liberalization of the credit policy can result in an increase in the risk of bad debts and a decrease in cash inflows.

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Most popular questions from this chapter

Maxim Air Filters Inc. plans to borrow $300,000 for one year. Northeast National Bank will lend the money at 10 percent interest and requires a compensating of 20 percent. What is the effective rate of interest?

Global Services is considering a promotional campaign that will increase annual credit sales by \(450,000. The company will require investments in accounts receivable, inventory, and plant and equipment. The turnover for each is as follows:

Accounts receivable

2X

Inventory

6X

Plant and equipment

1X

All \)450,000 of the sales will be collectible. However, collection costs will be 6 percent of sales, and production and selling costs will be 71 percent of sales. The cost to carry inventory will be 4 percent of inventory. Depreciation expense on plant and equipment will be 5 percent of plant and equipment. The tax rate is 30 percent.

a. Compute the investments in accounts receivable, inventory, and plant and equipment based on the turnover ratios. Add the three together.

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d. What is the total cost of ordering and carrying inventory?

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10%

Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is \(150,000. The company can borrow \)150,000 for three years at 10 percent annual interest or for one year at 8 percent annual interest.

How much would Sauer Food Company save in interest over the three-year life of the computer system if the one-year loan is utilized and the loan is rolled over (reborrowed) each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3? What would be the total interest cost compared to the 10 percent, three-year loan?
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