Chapter 07: Current Asset Management
7-21
Then compute return on incremental investment.
$11,022 18.37%
$60,000 =
Yes, extend credit. 18.37% is greater than 10%.
21. Credit policy and return on investment (LO4) Global Services is considering a
promotional campaign that will increase annual credit sales by $400,000. The company
will require investments in accounts receivable, inventory, and plant and equipment. The
turnover for each is as follows:
Accounts receivable ……………………………..
4x
Inventory ……………………………………………
8x
Plant and equipment …………………………….
2x
All $400,000 of the sales will be collectible. However, collection costs will be 4 percent of
sales, and production and selling costs will be 76 percent of sales. The cost to carry
inventory will be 8 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.
b. Compute the accounts receivable collection costs and production and selling costs
and add the two figures together.
c. Compute the costs of carrying inventory.
d. Compute the depreciation expense on new plant and equipment.
e. Add together all the costs in parts b, c, and d.
f. Subtract the answer from part e from the sales figure of $400,000 to arrive at income
before taxes. Subtract taxes at a rate of 30 percent to arrive at income after taxes.
g. Divide the aftertax return figure in part f by the total investment figure in part a. If the
firm has a required return on investment of 12 percent, should it undertake the
promotional campaign described throughout this problem.
7-21. Solution:
Global Services
a. Accounts receivable = sales/accounts receivable turnover
Chapter 07: Current Asset Management
7-22
$100,000 $400,000/4=
Inventory = sales/inventory turnover
$50,000 $400,000/8=
Plant and equipment = sales/(plant and equipment turnover)
$200,000 400,000
$ / 2
=
$350,000 total investment
7-21. (Continued)
b. Collection cost = 4% × $400,000 $ 16,000
Production and selling costs = 76% × $400,000 = 304,000
Total costs related to accounts receivable $320,000
c. Cost of carrying inventory
Chapter 07: Current Asset Management
7-23
Taxes (30%) 19,800
Income after taxes $ 46,200
g.
Income after taxes $46,200 13.2%
Total investment 350,000
==
Yes, it should undertake the campaign.
The aftertax return of 13.2% exceeds the required rate of
return of 12%.
22. Continuation of Problem (LO4) In Problem 21, if inventory turnover had only been 4 times:
a. What would be the new value for inventory investment?
b. What would be the return on investment? You need to recompute the total investment
Should the campaign be undertaken?
7-22. Solution:
Global Services (Continued)
a. Inventory = sales/inventory turnover
$100,000 = $400,000/4
b. New Total Investment
Accounts receivable $100,000
Total Cost of the Campaign
Cost of carrying inventory
Chapter 07: Current Asset Management
New Income After Taxes
Sales $400,000
– total costs 342,000 ($334,000 + $8,000
(Problems 23-26 are a series and should be taken in order.)
23. Credit policy decision with changing variables (LO4) Dome Metals has credit sales of
$144,000 yearly with credit terms of net 30 days, which is also the average collection
period. Dome does not offer a discount for early payment, so its customers take the full 30
days to pay. What is the average receivables balance? Receivables turnover?
7-23. Solution:
Dome Metals
Sales/360 days = average daily sales
$144,000/360 = $400
Chapter 07: Current Asset Management
7-25
24. If Dome offered a 2 percent discount for payment in 10 days and every customer took
advantage of the new terms, what would the new average receivables balance be? Use the
full sales of $144,000 for your calculation of receivables.
7-24. Solution:
25. If Dome reduces its bank loans, which cost 10 percent, by the cash generated from its
reduced receivables, what will be the net gain or loss to the firm (don’t forget the 2
percent)? Should it offer the discount?
7-25. Solution:
Old receivables – new receivables = Funds freed by
with discount discount
$12,000 – $4,000 = $8,000 discount
26. Assume that the new trade terms of 2/10, net 30 will increase sales by 15 percent because
the discount makes the Dome’s price competitive. If Dome earns 20 percent on sales before
discounts, should it offer the discount? (Consider the same variables as you did for
problems 23 through 25 as will as increase sales.)
7-26. Solution:
Chapter 07: Current Asset Management
7-26
New sales = $144,000 × 1.15 = $165,000
Change in sales = $165,000 – $144,000 = $ 21,600
COMPREHENSIVE PROBLEM
Logan Distributing Company (receivables and inventory policy) (LO 04 & 05) Logan
Distributing Company of Atlanta sells fans and heaters to retail outlets through out the Southeast.
Joe Logan, the president of the company, is thinking about changing the firm’s credit policy to
attract customers away from competitors. The present policy calls for a 1/10, net 30 cash
discount. The new policy would call for a 3/10, net 50 cash discount. Currently, 30 percent of
Logan customers are taking the discount, and it is anticipated that this number would go up to 50
percent with the new discount policy. It is further anticipated that annual sales would increase
from a level of $400,000 to $600,000 as a result of the change in the cash discount policy.
The increased sales would also affect the inventory level. The average inventory carried by
Logan is based on a determination of an EOQ. Assume sales of fans and heaters increase from
15,000 to 22,500 units. The ordering cost for each order is $200 and the carrying cost per unit is
$1.50 (these values will not change with the discount). The average inventory is based on
EOQ/2. Each unit in inventory has an average cost of $12.
Cost of goods sold is equal to 65 percent of net sales; general and administrative expenses are
15 percent of net sales, and interest payments of 14 percent will only be necessary for the
increase in the accounts receivable and inventory balances. Taxes will be 40 percent of before–
tax income.
a. Compute the accounts receivable balance before and after the change in the cash
discount policy. Use the net sales (total sales minus cash discounts) to determine the
average daily sales.
b. Determine EOQ before and after the change in the cash discount policy. Translate this
into average inventory (in units and dollars) before and after the change in the cash
discount policy.
Chapter 07: Current Asset Management
7-27
c. Complete the following income statement.
Before Policy
Change
After Policy
Change
Net sales (Sales – Cash discounts) ……………
Cost of goods sold …………………………………
Gross profit ………………………………………….
General and administrative expense ………….
Operating profit …………………………..………..
Interest on increase in accounts
receivable and inventory (14%) …………….
Income before taxes……………………………….
Taxes…………………………………………………..
Income after taxes …………………………………
d. Should the new cash discount policy be utilized? Briefly comment.
CP 7-1. Solution:
Logan Distributing Company
a. Accounts receivable = average collection × average daily
period sales
Before
Average collection period
Chapter 07: Current Asset Management
( )( )( )
$400,000 .01 .30 $400,000
Credit sales Discount
360 days 360 days
$400,000 $1,200
360 days
$398,800
360 days
Average daily sales $1,107.78
−
−=
−
=
=
=
Accounts receivable = 24 days × $1,107.78 = $26,586.72
before policy change
After
Average collection period
CP 7-1. (Continued)
Average daily sales
( )( )( )
$600,000 .03 .50 $600,000
Credit sales discount
360 days 360 days
$600,000 $9,000
360 days
$591,000
360 days
−
−=
−
=
=
Chapter 07: Current Asset Management
7-29
b. Before
2SO
EOQ C
=
2 15,000 $200 $6,000,000 4,000,000 2,000 units
$1.50 $1.50
= = =
After
2 22,000 $200 $9,000,000 6,000,000 2,449.49
$1.50 $1.50
= = =
Average inventory
Before
2,000 1,000 units 1,000 units $12 $12,000
2= =
Chapter 07: Current Asset Management
7-30
CP 7-1. (Continued)
After
2,449.49
2=
c.
Before
Policy
Change
After
Policy
Change
Net sales (sales – cash discount)
$398,800
$591, 000
Cost of goods sold (65%)
259,220
384,150
Gross Profit
139,580
206,850
General and admin. expense (15%)
59,820
88,650
Operating profit
79,760
118,200
*Interest on increase in accounts
receivable and inventory (14%)
3,550.45
Income before taxes
79,760
114,649.55
Taxes (40%)
31,904
45,859.82
Income after taxes
$ 47,856
$ 68,789.73
*14% AR
( )
14% $49,250.10 $26,586.72= −
14% $22,663.38=
$3,172.87=
14% INV
( )
=14% $14,697 $12,000−
14% $2.697=
$ 377.58=
$3,550.45
d. The new cash discount policy should be utilized. The interest
1,224.75 units 1,224.75 units ×$12 =
or 1,225 (rounded) $14,697 or $14,700
(rounded)