Question

Q2) A company is evaluating the extension of credit to a new group of customers.

Although these customers will provide $180,000 in additional credit sales, 12% are likely
to be uncollectible. The company will also incur $16,200 in additional collection
expense. Production and marketing costs represent 72% of sales. The firm is in a 34% tax
bracket and has a receivables turnover of four times. No other asset buildup will be
required to service the new customers. The firm has a 10% desired return.
has a
a. Calculate the incremental income after taxes and the return on incremental
investment. Should the company extend credit to these customers?
b. Based on the income level determined in (a), should credit be extended if an
additional investment in inventory is considered? Assume an inventory turnover
of 1.6 times.

Answer 1

Explanation:

a. To calculate the incremental income after taxes, we need to determine the incremental costs and revenues associated with extending credit to the new customers. The additional credit sales will generate $180,000 in revenue, but we need to subtract the expected uncollectible amount of 12% * $180,000 = $21,600. The net additional credit sales will be $180,000 - $21,600 = $158,400.

The production and marketing costs will be 72% * $180,000 = $129,600. The total incremental costs will be $129,600 + $16,200 (collection expense) = $145,800.

The incremental income before taxes will be $158,400 - $145,800 = $12,600. The income tax will be 34% * $12,600 = $4,284. The incremental income after taxes will be $12,600 - $4,284 = $8,316.

To calculate the return on incremental investment, we need to determine the incremental investment required to extend credit to the new customers. Since no additional investment in assets is required, the incremental investment will be equal to the incremental costs of $145,800. The return on incremental investment will be $8,316 / $145,800 = 5.7%.

Based on the return on incremental investment of 5.7%, the company should not extend credit to the new customers, as it is below the desired return of 10%.

b. If an additional investment in inventory is required to extend credit to the new customers, we will need to recalculate the incremental income after taking into account the additional investment. If the additional investment in inventory is $x, the incremental investment will be $145,800 + $x. The incremental income before taxes will be $158,400 - ($129,600 + $16,200 + $x) = $12,600 - $x. The income tax will be 34% * ($12,600 - $x) = $4,284 - $x * 0.34. The incremental income after taxes will be ($12,600 - $x) - ($4,284 - $x * 0.34) = $8,316 - $x * 0.34.

To determine whether credit should be extended, we need to compare the return on incremental investment to the desired return of 10%. The return on incremental investment will be ($8,316 - $x * 0.34) / ($145,800 + $x). Setting this equal to the desired return of 10% and solving for x, we find that the additional investment in inventory cannot exceed $24,764 for the company to meet its desired return. If the additional investment in inventory is less than or equal to $24,764, the company should extend credit to the new customers. If it is greater than $24,764, the company should not extend credit to the new customers.