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Unformatted text preview: rease Negative If credit standards were tightened, the opposite effects would be expected.
EXAMPLE Dodd Tool, a manufacturer of lathe tools, is currently selling a product for $10
per unit. Sales (all on credit) for last year were 60,000 units. The variable cost per
unit is $6. The firm’s total fixed costs are $120,000.
The firm is currently contemplating a relaxation of credit standards that is
expected to result in the following: a 5% increase in unit sales to 63,000 units; an
increase in the average collection period from 30 days (its current level) to 45
days; an increase in bad-debt expenses from 1% of sales (the current level) to 2%.
The firm’s required return on equal-risk investments, which is the opportunity
cost of tying up funds in accounts receivable, is 15%.
To determine whether to relax its credit standards, Dodd Tool must calculate
its effect on the firm’s additional profit contribution from sales, the cost of the
marginal investment in accounts receivable, and the cost of marginal bad debts.
Additional Profit Contribution from Sales Because fixed costs...
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