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 cost of the marginal cash discount?
A) $230,625
B) $768,750
C) $300,000
D) $307,500

Question

Quizplus · Accepted Answer

The cost of the marginal cash discount is the difference between the cost of the trade credit and the cost of the cash discount for the next level of credit terms. In this case, the cost of the trade credit is 2% per month (24% per year), and the cost of the cash discount for the next level of credit terms (2/10, net 60) is 24.36% per year. Therefore, the cost of the marginal cash discount is:
($10,000,000) x (24.36% - 24%) x (60/365) = $230,625.
Therefore, choosing the 2/10, net 60 credit terms is the best choice as it provides the company with the lowest cost of credit.