Question

Johnson Electronics is considering extending trade credit to some customers previously considered poor risks. Sales would increase by $125,000 if credit were extended to these new customers. Of the new accounts receivable generated, 8% will prove to be uncollectible. Additional collection costs will be 3% of sales, and production and selling costs will be 80% of sales. The firm is in the 30 percent tax bracket.

A. Compute the incremental income after taxes.
B. What will Johnson’s incremental return on sales be if these new credit customers are accepted?
C. If the accounts receivable turnover ratio is 6 to 1, and no other asset buildup is needed to serve the new customers, what will Johnson’s incremental return on new average investment be?

Answer 1

To calculate the incremental income after taxes, subtract the tax amount from the incremental income before taxes. The incremental return on sales is calculated by dividing the incremental income after taxes by the incremental sales. The incremental return on new average investment is calculated by dividing the incremental income after taxes by the average investment in accounts receivable.

Step-by-step explanation:

To compute the incremental income after taxes, we need to calculate the incremental sales, incremental collection costs, incremental production and selling costs, and the tax amount. The incremental sales from extending credit to new customers is $125,000. The incremental collection costs are 3% of sales, which is $3,750. The incremental production and selling costs are 80% of sales, which is $100,000. The incremental income before taxes is the difference between sales and collection costs minus production and selling costs, which is $21,250. To compute the incremental income after taxes, we need to subtract the tax amount. The firm is in the 30% tax bracket, so the tax amount is 30% of the incremental income before taxes, which is $6,375. Therefore, the incremental income after taxes is $14,875.

To calculate the incremental return on sales, we divide the incremental income after taxes by the incremental sales and multiply by 100. So, the incremental return on sales is ($14,875 / $125,000) x 100 = 11.9%.

To calculate the incremental return on new average investment, we need to find the average investment in accounts receivable. The accounts receivable turnover ratio is 6 to 1, so the average collection period is 1 / 6 = 0.1667 years. We can use this to find the average investment in accounts receivable as follows: average investment in accounts receivable = (incremental sales / 2) x collection period = ($125,000 / 2) x 0.1667 = $10,415.85. The incremental return on new average investment is the incremental income after taxes divided by the average investment in accounts receivable, multiplied by 100. So, the incremental return on new average investment is ($14,875 / $10,415.85) x 100 = 142.7%.

Answer 2

net increase in sales = $125,000 x (1 - 8% - 3%) = $111,250

net increase in costs = $125,000 x 80% = $100,000

average investment in assets = $125,000 / 6 = $20,833

A. Compute the incremental income after taxes.

• incremental income = $111,250 - $100,000 = $11,250

B. What will Johnson’s incremental return on sales be if these new credit customers are accepted?

• return on sales = $11,250 / $125,000 = 9%

C. If the accounts receivable turnover ratio is 6 to 1, and no other asset buildup is needed to serve the new customers, what will Johnson’s incremental return on new average investment be?

• = $11,250 / $20,833 = 54%