18. Curtis Toy Manufacturing Company is evaluating the extension of credit to a new group of customers. Although these customers will provide $240,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur $21,000 in additional collection expense. Production and marketing costs represent 72 percent of sales. The company is in a 30 percent tax bracket and has a receivables turnover of six times. No other asset buildup will be required to service the new customers. The firm has a 10 percent desired return on investment. a.
Should Curtis extend credit to these customers? Added sales$240,000 Accounts uncollectible (12% of new sales) 28,800 Annual incremental revenue211,200 Collection costs21,000 Production and selling costs (72% of new sales) 172,800 Annual income before taxes17,400 Taxes (30%) 5,220 Incremental income after taxes$ 12,180 Yes, extend credit to these customers as 43. 5% incremental return is greater than 14. 5%. b. Should credit be extended if 14 percent of the new sales prove uncollectible? Added sales$240,000 Accounts uncollectible (14% of new sales)– 33,600
Annual incremental revenue$206,400 Collection costs– 21,000 Production and selling costs (72% of new sales)–172,800 Annual income before taxes$ 12,600 Taxes (30%)– 3,780 Incremental income after taxes$ 8,820 Yes, extend credit. c. Should credit be extended if the receivables turnover drops to 1. 5 and 12 percent of the accounts are uncollectible (as was the case in part a)? If receivable turnover drops to 1. 5x, the investment in accounts receivable would equal $240,000/1. 5 = $160,000. The return on incremental investment, assuming a 12% uncollectible rate, is 7. 61%.
The credit should not be extended. 7. 61% is less than the desired 10%. 19. Reconsider problem 18. Assume the average collection period is 120 days. All other factors are the same (including 12 percent uncollectibles). Should credit be extended? First compute the new accounts receivable balance. Accounts receivable = average collection period x average daily sales 120 days x or Accounts receivable = sales/accounts receivable turnover Accounts receivable turnover = $240,000/3 = $80,000 Then compute return on incremental investment. Yes, extend credit, 15. 23% is greater than 10%.