Question

Johnson Electronics is considering extending trade credit to some customers previously considered poor risks. Sales would increase by $150,000 if credit is extended to these new customers. Of the new accounts receivable generated, 5 percent will prove to be uncollectible. Additional collection costs will be 2 percent of sales, and production and selling costs will be 74 percent of sales. The firm is in the 35 percent tax bracket.

c. If the receivable turnover ratio is 3 to 1 and no other asset build-up is needed to serve the new customers, what will Johnson’s incremental return on new average investment be?

Short answer

The incremental return on the new average return is 37.05%.

Step-by-step solution

Calculation of receivables

The receivables are $50,000.

$\begin{array}{rcl}\mathrm{Receivables}\mathrm{turnover}& =& \frac{\mathrm{Sales}}{\mathrm{Receivables}}\\ \mathrm{Receivables}& =& \frac{\mathrm{Sales}}{\mathrm{Receivables}\mathrm{turnover}}\\ \mathrm{Receivables}& =& \frac{\$150,000}{3}\\ \mathrm{Receivables}& =& \$50,000\end{array}$

Calculation of incremental return on new average return

The incremental return on the new average return is 37.05%.

$\begin{array}{rcl}\mathrm{Incremental}\mathrm{return}\mathrm{on}\mathrm{new}\mathrm{average}\mathrm{return}& =& \frac{\mathrm{Incremental}\mathrm{income}}{\mathrm{Receivables}}\times 100\\ & =& \frac{\$18,525}{\$50,000}\times 100\\ & =& 37.05\%\end{array}$