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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×100=$5,720$48,750×100=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

By using long-term financing to finance part of temporary current assets, a firm may have less risk but lower returns than a firm with a normal financing plan. Explain the significance of this statement.

Since the mid-1960s, corporate liquidity has been declining. What reasons can you give for this trend?

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.

c. Should Henderson liberalize credit if a 16 percent after-tax return on investment is required?

Esquire Products Inc. expects the following monthly sales:

January

\(28,000

February

\)19,000

March

\(12,000

April

\)14,000

May

\(8,000

June

\)6,000

July

\(22,000

August

\)26,000

September

\(29,000

October

\)34,000

November

\(42,000

December

\)24,000

Total annual sales

\(264,000

Cash sales are 40 percent in a given month, with the remainder going into accounts receivable. All receivables are collected in the month following the sale. Esquire sells all of its goods for \)2 each and produces them for \(1 each. Esquire uses level production, and average monthly production is equal to annual production divided by 12.

e. Determine total current assets for each month. Include cash, accounts receivable, and inventory. Accounts receivable equal sales minus 40 percent of sales for a given month. Inventory is equal to ending inventory (part a) times the cost of \)1 per unit.

Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory?

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