Question

Slow Roll Drum Co. is evaluating the extension of credit to a new group of customers. Although these customers will provide $486,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur $17,800 in additional collection expense. Production and marketing costs represent 75 percent of sales. The firm is in a 35 percent tax bracket. No other asset buildup will be required to service the new customers. The firm has a desired return of 12 percent. Assume the average collection period is 90 days.

Compute the return on incremental investment. (Input your answer as a percent rounded to 2 decimal places. Use a 360-day year.)

Answer 1

Where the above conditions are given, it is to be noted that the return on incremental investment is about 45.93%

When you want to compute the return on incremental invesment, you have to first consider the incremental net income. When you have established that, you can now divide it by the increamental invesment.

Step 1 - compute the increament in sales:

$486,000 x (1- uncollectible percentage)

= 486,000 x (1-0.12)

= 427,680

Scondly step is to compute the increamental expnse of collection

This is already given as $17,800

Thirdly, derive the incremntal Gross profit

$427,680 x (1-0.75)

=106 920

Fourth step is to compute the incremental net income (before taxation):

$106,920 - $17,800

= $89,120

Fifth step is to compute the incremental net income (after taxation)
$89,120 x (1-Tax Rate)

= $89,120 x (1-0.35)

= $57,848

Now we compute the return on incremntal invesment which is given as:

[Incremental Net Income/Incremental Investment] x (360/average collection period)

= (57,848/(486,000+17,800)) x (360/90)

= 0.11482334259 x 4

= 0.45929337036

Convert to percentage and we'll get:

=0.45929337036 x 100

= 45.929337036%

≈ 45.93%

Hence, it is correct to state that the return on incremental investment is about 45.93%.