A firm is considering relaxing credit standards which will result in an increase in annual sales from$3 million to $3.75 million, a decrease in the cost of annual sales from $2,225,000 to $2,000,000, anincrease in additional profit contribution from sales of $10,000, and an increase in the average collection period of 15 days, from 20 to 35 days. The bad debt loss is expected to increase from 1 percent to 1.5 percent of sales. The firm's required return on investments is 15 percent. The net result of the firm relaxing its credit standards is ___________.
A) -$16,875
B) -$26,875
C) $10,000
D) -$16,250

Question

Quizplus · Accepted Answer

To calculate the net result of the firm relaxing its credit standards, we need to calculate the increase in profit contribution from sales, the decrease in the cost of sales, the increase in bad debt loss, and the increase in the average collection period.

Increase in profit contribution from sales = $10,000 
Decrease in the cost of sales = $225,000 ($2,225,000 - $2,000,000) 
Increase in bad debt loss = $22,500 ($3,750,000 x 1.5% - $3,000,000 x 1%) 
Increase in average collection period = 15 days

To calculate the net result, we need to use the formula:

Net Result = Increase in Profit Contribution - Decrease in Cost of Sales - Increase in Bad Debt Loss - Opportunity Cost of Funds Tied Up in Receivables

Opportunity Cost of Funds Tied Up in Receivables = (Average Accounts Receivable / 2) x Required Return on Investment x (Increase in Average Collection Period / 365)

Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
Beginning Accounts Receivable = $3,000,000 / 365 x 20 = $1,643,836
Ending Accounts Receivable = $3,750,000 / 365 x 35 = $3,616,438
Average Accounts Receivable = ($1,643,836 + $3,616,438) / 2 = $2,630,137.

Opportunity Cost of Funds Tied Up in Receivables = ($2,630,137 / 2) x 0.15 x (15 / 365) = $6,375.

Net Result = $10,000 - $225,000 - $22,500 - $6,375 = -$16,875.

Therefore, the net result of the firm relaxing its credit standards is a decrease of $16,875. Answer choice A) is correct.

A Firm Is Considering Relaxing Credit Standards Which Will Result