Question

Fast Turnstiles Co. is evaluating the extension of credit to a new group of customers. Although these customers will provide \(180,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur \)16,200 in additional collection expense. Production and marketing costs represent 72 percent of sales. The firm is in a 34 percent tax bracket and has a receivables turnover of four times. No other asset build-up will be required to service the new customers. The firm has a 10 percent desired return.

c. Calculate the return on incremental investment if the receivables turnover drops to 1.6, and 12 percent of the accounts are uncollectible. Should credit be extended if the receivables turnover drops to 1.6, and 12 percent of the accounts are uncollectible (as in part a)?

Short answer

The incremental income after-tax is $12,172, the incremental after-tax return on investment is 10.89% and the company should extend credit to these customers.

Step-by-step solution

Information provided in the question

Increase in sales = $180,000

Production and marketing costs = 72%

Uncollectible accounts = 12%

Collection costs = $16,200

Income taxes = 34%

Accounts receivables turnover = 1.6 times

Calculation of incremental income after taxes

The incremental income after taxes is $12,172.

Particulars	Amount
Additional sales	$180,000
Accounts uncollectible (12% of additional sales)	($21,600)
Annual incremental revenue	$158,400
Collection costs	($16,200)
Production and marketing costs (72% of additional sales)	($129,600)
Annual income before taxes	$12,600
Taxes (34%)	($4,284)
Incremental income after taxes	$12,172

Calculation of investment in accounts receivables

The investment required in accounts receivables is $112,500.

$\begin{array}{rcl}\mathrm{Investment}\mathrm{in}\mathrm{accounts}\mathrm{receivables}& =& \frac{\mathrm{Increase}\mathrm{in}\mathrm{sales}}{\mathrm{Accounts}\mathrm{receivables}\mathrm{turnover}}\\ & =& \frac{\$180,000}{1.6}\\ & =& \$112,500\end{array}$

Calculation of incremental after-tax return on investment

The incremental after-tax return on investment is 10.89%.

$\begin{array}{rcl}\mathrm{Incremental}\mathrm{after}\mathrm{tax}\mathrm{return}\mathrm{on}\mathrm{investment}& =& \frac{\mathrm{Incremental}\mathrm{income}}{\mathrm{Investment}\mathrm{in}\mathrm{receivables}}\times 100\\ & =& \frac{\$12,172}{\$112,500}\times 100\\ & =& 10.89\%\end{array}$

Decision for extending credit

The expected incremental return is 10.89% and this return is more than the desired incremental return, so the company should consider extending the credit.