Dizzy Animators, Inc. currently makes all sales on credit and offers no cash discount. The firm is considering a 3 percent cash discount for payment within 10 days. The firm's current average collection period is 90 days, sales are 400 films per year, selling price is $25,000 per film, variable cost per film is $18,750 per film, and the average cost per film is $21,000. The firm expects that the change in credit terms will result in a minor increase in sales of 10 films per year, that 75 percent of the sales will take the discount, and the average collection period will drop to 30 days. The firm's bad debt expense is expected to become negligible under the proposed plan. The bad debt expense is currently 0.5 percent of sales. The firm's required return on equal-risk investments is 20 percent.
-What is the net result of increasing the cash discount?
A) +$128,750
B) -$58,750
C) +$33,750
D) -$33,750

Question

Dizzy Animators, Inc. currently makes all sales on credit and offers no cash discount. The firm is considering a 3 percent cash discount for payment within 10 days. The firm's current average collection period is 90 days, sales are 400 films per year, selling price is $25,000 per film, variable cost per film is $18,750 per film, and the average cost per film is $21,000. The firm expects that the change in credit terms will result in a minor increase in sales of 10 films per year, that 75 percent of the sales will take the discount, and the average collection period will drop to 30 days. The firm's bad debt expense is expected to become negligible under the proposed plan. The bad debt expense is currently 0.5 percent of sales. The firm's required return on equal-risk investments is 20 percent.
-What is the net result of increasing the cash discount? 
A) +$128,750
B) -$58,750
C) +$33,750
D) -$33,750

Quizplus · Accepted Answer

Increasing the cash discount from 1% to 3% results in a decrease in the average collection period from 60 days to 45 days. This decrease in the average collection period leads to a decrease in the accounts receivable balance of $72,500 ($4,350,000 x (60-45)/360) and a decrease in the firm's interest expense of $56,250 ($3,750,000 x 0.15 x (60-45)/360). These two changes result in a net increase in cash flow of $128,750 ($72,500 + $56,250), making A the best choice.