Covers, Inc. (CI) sells its stainless steel products on terms of "2/10, net 40." CI is considering granting credit to retailers with total assets as low as $500,000. Currently the lowest asset limit is $750,000. CI believes sales will increase $7 million from the new credit group but the average collection period for this new group will be 60 days versus the current average collection period of 35 days. If management estimates that 20% of the new customers will take the cash discount but 4% of the new business will be written off as a bad-debt loss, should CI lower its credit standards? Why or why not? Assume CI's variable cost ratio is 0.7 and its required pretax rate of return on receivables investment is 15%.

Question

Quizplus · Accepted Answer

The pretax profits will increase by $1,619,397 if CI lowers its credit standards. This is because the increase in sales ($7 million) will outweigh the increase in bad debt expense ($280,000) and the decrease in cash discount revenue ($140,000).