Notes: In the most recent fiscal year, its sales were $18 million with $2,500,000 in after tax profits. Historically, the firm shipped out its goods with a 30 day pay period allowed, with no cash discount offered. In looking over the numbers, Beth (CEO) felt the customers, on average, were taking over 30 days to pay. The receivables were based on average daily credit sales of $54,274 throughout the year. Beth told AL (CFO) to consider the impact of a cash discount on the accounts receivable balance of the firm as well as its profitability. AL evaluated the effect of the three alternative cash discount policies shown in Table 2. He ran some pilot studies among customers and determined the results below. 10% of customers would take advantage of the 1% discount by paying within 10 days. If the 2% discount were offered, 25% would take it, and if the 3% discount were offered, 60% of the customers would take advantage of it. It was assumed in each case that those who do not take the discount would pay at the end of 30 days.
Table 1. Accounts Receivables Outstanding, December 2006
Days Outstanding Amount
0-10 20,000
10-20 150,000
20-30 400,000
30-40 650,000
40-50 430,000
50-60 350,000
Total A/R 2,000,000
Table 2. New Terms for Cash Discounts
Alternative Terms
1 1/10,net 30
2 2/10,net 30
3 3/10,net 30
He then computed the new average collection period(s) based on the data in the prior paragraph. With an assumption of average daily credit sales remaining at $54,274 per day, he also computed the anticipated new accounts receivable balance based on the three different cash discount policies. He was informed by his corporate treasurer that any freed up funds from accounts receivable could be used elsewhere in the corporation to earn a return of 18%.
Required:
1. Compute the current average collection period based on the data in Table 1. In doing this, multiply the midpoint of the days outstanding, by the weight assigned to that category. For example, the midpoint of the second company is 15 days and the category represents 7.5% of total accounts receivable ($150,000/2,000,000). Its value is 1.125 days (15 days * .075). After this process is followed for all six categories, add up the total to get the average collection period.
2. Compute the new average collection period based on the terms in Table 2 and the results of the pilot study. Use the simplifying assumption that under the new policies all customers will all pay at the end of the 10th day or the end of the 30th day.
i.e., for the 1/10, net 30
10% * 10 days= 1 day
90% * 30 days= 27 days
28 days average collection period
3. Assuming average daily credit sales remain at $54,274 per day, what will be the new accounts receivable balance based on the three new cash discount policies?
Accounts receivable= average collection period * average daily credit sales
4. Compute the cost of the cash discount based on the three policies under consideration. Recall the total credit sales were $18 million. Multiply total credit sales times the percent that use the discount for each new discount policy times the size of the discount.
5. Compute the amount of freed up funds based on the three different cash discount policies based on the following:
Old accounts receivable (given in table 1)
New accounts receivable (Question 3)
Freed up funds
6. Assuming an 18% return can be earned on the freed up funds, what is the return that can be earned under the three cash discount policies?
7. Subtract the cost of the cash discount (Question 4) from the return on the freed up funds (Question 6) to determine the actual profitability or loss under the three cash discount policies.
Which of the three policies is the most profitable?
8. After looking at all the data, Beth decides to only consider Alternatives 1 and 2. She decides that the 2/10, net 30 cash discount could increase credit sales by $1 million. The 1/10, net 30 is assumed to have no impact on sales. Assume a 9% before tax profit margin on the new sales.* Also assume the 2% cash discount must be subtracted. Further, assume the new sales will require a new investment in accounts receivable of $27,750. These funds could earn 20% if invested elsewhere. (The 20% is return on investment, whereas the 9% referred to above is return on sales.)