Question

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.

b. What would be Henderson’s incremental after-tax return on investment?

Short answer

The incremental after-tax return on investment is 35.2%.

Step-by-step solution

Information provided in the question

Increase in sales = $65,000

Production and selling costs = 74%

Uncollectible accounts = 9%

Collection costs = 6%

Income taxes = 20%

Accounts receivables turnover = 4 times

Calculation of incremental income after taxes

The incremental income after taxes is $5,720.

Particulars	Amount
Additional sales	$65,000
Accounts uncollectible (9% of additional sales)	($5,850)
Annual incremental revenue	$59,150
Collection costs (6% of additional sales)	($3,900)
Production and selling costs (74% of additional sales)	($48,100)
Annual income before taxes	$7,150
Taxes (20%)	($1,430)
Incremental income after taxes	$5,720

Calculation of incremental after-tax return on investment

The incremental after-tax return on investment is 35.2%.

$\begin{array}{rcl}\mathrm{Incremental}\mathrm{after}-\mathrm{tax}\mathrm{return}\mathrm{on}\mathrm{investment}& =& \frac{\mathrm{Incremental}\mathrm{income}}{\mathrm{Investment}\mathrm{in}\mathrm{receivables}}\times 100\\ & =& \frac{\$5,720}{\$16,250}\times 100\\ & =& 35.2\%\end{array}$