In the following paragraphs we explain how the

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Unformatted text preview: projected net income. In the following paragraphs, we explain how the numbers in the table were calculated. Monroe’s annual sales are $400 million. Under its current credit policy, 50 percent of those customers who pay do so on Day 10 and take the discount, 40 percent pay on Day 30, and 10 percent pay late, on Day 40. Thus, Monroe’s days sales outstanding is (0.5)(10) (0.4)(30) (0.1)(40) 21 days, and discounts total (0.01)($400,000,000)(0.5) $2,000,000. The cost of carrying receivables is equal to the average receivables balance times the variable cost percentage times the cost of money used to carry receivables. The firm’s variable cost ratio is 70 percent, and its pre-tax cost of capital invested in receivables is 20 percent. Thus, its annual cost of carrying receivables is $3 million: Cost Sales Variable (DSO) ° per ¢ ° cost ¢ ° of ¢ day ratio funds (21)($400,000,000/365)(0.70)(0.20) Table 27-4 Cost of carrying receivables $3,221,918 $3 million. Monroe Manufacturing Company: Analysis of Changing Credit Policy (Millions of Dollars) Projected 2005 Net Income under Current Credit Policy (1) Gross sales Less discounts Net sales $400 Effect of Credit Policy Change (2) $130 Projected 2005 Net Income under New Credit Policy (3) $530 2 4 6 $398 $126 $524 Production costs, including overhead 280 91 371 Profit before credit costs and taxes $118 $ 35 $153 Cost of carrying receivables 3 2 5 Credit analysis and collection expenses 5 3 2 10 22 32 $100 $ 14 $114 50 7 57 7 $ 57 Credit-related costs: Bad debt losses Profit before taxes State-plus-federal taxes (50%) Net income $ 50 $ Note: The above statements include only those cash flows incremental to the credit policy decision. 27-10 Chapter 27 Providing and Obtaining Credit Only variable costs enter this calculation because this is the only cost element in receivables that must be financed. We are seeking the cost of carrying receivables, and variable costs represent the firm’s investment in the cost of goods sold. Even though Monroe spends $5 million annually to analyze accounts and to collect bad debts, 2.5 percent of sales will never be collected. Bad debt losses therefore amount to (0.025)($400,000,000) $10,000,000. Monroe’s new credit policy would be 2/10, net 40 versus the old policy of 1/10, net 30, so it would call for a larger discount and a longer payment period, as well as a relaxed collection effort and lower credit standards. The company believes that these changes will lead to a $130 million increase in sales, to $530 million per year. Under the new terms, management believes that 60 percent of the customers who pay will take the 2 percent discount, so discounts will increase to (0.02)($530,000,000) (0.60) $6,360,000 $6 million. Half of the nondiscount customers will pay on Day 40, and the remainder on Day 50. The new DSO is thus estimated to be 24 days: (0.6)(10) (0.2)(40) (0.2)(50) 24 days. Also, the cost of carrying receivables will increase to $5 million: (24)($530,000,000/365)(0.70)(0.20) $4,878,904 $5 million.4 The company plans to reduce its annual credit analysis and collection expenditures to $2 million. The reduced credit standards and the relaxed collection effort are expected to raise bad debt losses to about 6 percent of sales, or to (0.06) ($530,000,000) $31,800,000 $32,000,000, which is an increase of $22 million from the previous level. The combined effect of all the changes in credit policy is a projected $7 million annual increase in net income. There would, of course, be corresponding changes on the projected balance sheet—the higher sales would necessitate somewhat larger cash balances, inventories, and, depending on the capacity situation, perhaps more fixed assets. Accounts receivable would, of course, also increase. Because these asset increases would have to be financed, certain liabilities and/or equity would have to be increased. The $7 million expected increase in net income is, of course, an estimate, and the actual effects of the change could be quite different. In the first place, there is uncertainty—perhaps quite a lot—about the projected $130 million increase in sales. Indeed, if the firm’s competitors matched its changes, sales might not rise at all. Similar uncertainties must be attached to the number of customers who would take discounts, to production costs at higher or lower sales levels, to the costs of carrying additional receivables, and to bad debt losses. In the final analysis, the decision will be based on judgment, especially concerning the risks involved, but the type of quantitative analysis set forth above is essential to the process. 4Since the credit policy change will result in a longer DSO, the firm will have to wait longer to receive its profit on the goods it sells. Therefore, the firm will incur an opportunity cost due to not having the cash from these profits available for investment. The dollar amount of this opportunity cost is equal to the old sales per day times the change in DSO times the contribution margin (1 Variable cost ratio) times the firm’s cost of carrying receivables, or Opportunity cost (Old sales/365)( DSO)(1 ($400/365)(3...
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This document was uploaded on 01/20/2014.

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