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.

e. Given the income determined in part b and the investment determined in part d, should Henderson extend more liberal credit terms?

Short answer

The company should not liberalize its credit policy.

Step-by-step solution

Calculation of incremental after-tax return on investment

The incremental after-tax return on investment is 11.74%.

$\begin{array}{rcl}\mathrm{Incremental}\mathrm{after}-\mathrm{tax}\mathrm{return}\mathrm{on}\mathrm{investment}& =& \frac{\mathrm{Incremental}\mathrm{income}}{\mathrm{Total}\mathrm{incremental}\mathrm{investment}}\times 100\\ & =& \frac{\$5,720}{\$48,750}\times 100\\ & =& 11.74\%\end{array}$

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.