Elwood Blues, vice president of sales for East-West Trading, Inc., wants to change the firm’s credit policy from 2/15, n40 to 2/15, n60, effective January 1, 2016. He is confident that the proposed relaxation will result in a 20 percent increase over the otherwise expected annual sales of $350,000 with the old policy. All sales are made on credit. The historical payment pattern under the present credit terms are as follows:
Under the old policy:
• 40 percent of the customers take advantage of the discount and pay in 15 days.
• 58 percent of the customers forgo the discount and pay in 40 days.
• The remaining 2 percent pay in 100 days.
Under the new credit policy, the payment pattern is expected to be as follows:
• 40 percent of the customers will take advantage of the discount and pay in 15 days.
• 57 percent of the customers will forgo the discount and pay in 60 days.
• The remaining 3 percent will pay in 100 days.
Bad debt expenses are expected to rise from 2 percent to 3 percent with the change in credit policy. Assume (i) any increase in current assets will be financed by short-term notes at an interest rate of 7 percent; (ii) long-term interest rate is 10 percent; (iii) income tax rate is 40 percent; (iv) cost of capital for East-West is 11 percent; (v) cost of goods sold is 80 percent of sales; (vi) other operating expenses is $10,000 under the old policy.
The pro forma balance sheet items of the company under the old policy would be as follows:
Cas Securities: 15,000
Inventory: 50,000
Plant and EQUIPMENT: 120,000
Common Stock: 25,000
Retained earnings: 50,000
Accounts Payable: 14.918
Notes Payable: 35,000
Long Term Debt: 30,000
Capital in Excess of Par: 60,000
Also assume that the cost of goods sold and other operating expenses in the income statement and all current asset and current liability items, except accounts receivable, vary directly with sales.
a. Calculate average collection periods and accounts receivable under the old and the new policies.
b. Develop pro forma income statements and balance sheets under the old and the new policies.
c. Calculate the incremental cash flows for 2016 and the subsequent years.
d. Advise Mr. Blues if he should adopt the new policy.