P13-7) Accounts receivable changes without bad debts
Tara’s Textiles currently has credit sales of $360 million per year and an average collection period of 60 days. Assume that the price of Tara’s products is $60 per unit and that the variable costs are $55 per unit. The firm is considering an accounts receivable change that will result in a 20% increase in sales and a 20% increase in the average collection period. No change in bad debts is expected The firm’s equal-risk opportunity cost on its investment in accounts receivable is 14%. (Note: Use a 365-day year.)
a) Calculate the additional profit contribution from new sales that the firm will realize if it makes the proposed change.
Current units = $360,000,000 $60 = 6,000,000 units
Increase = 6,000,000 x 20% = 1,200,000 new units
Additional profit contribution = ($60 - $55) x 1,200,000 units
= $6,000,000
b) What marginal investment in accounts receivable will result?
Average investment in accounts receivable=
Turnover, present plan=
Turnover, proposed plan=
Marginal Investment in A/R:
Average investment, proposed plan:
= $79,200,000
Average investment, present plan:
= 55,000,000
Marginal investment in A/R= $24,200,000
*Total units, proposed plan = existing sales of 6,000,000 units + 1,200,000 additional units.
c) Calculate the cost of the marginal investment in accounts receivable.
Cost of marginal investment in accounts receivable:
Marginal investment in A/R $24,200,000
Required return x .14
Cost of marginal investment in A/R $ 3,388,000
d) Should the firm implement the proposed change? What other information would be helpful in your analysis?
The additional profitability of $6,000,000 exceeds the additional costs of $3,388,000,
therefore the proposed change should be adopted, yet one would need estimates of
bad debt expenses, clerical costs, and some information about the uncertainty of the
sales forecast prior to adoption of the policy.