Warren Motor Company sells $30 million of its products to wholesalers on terms of "net 30." Currently, the firm's average collection period is 48 days. To speed up the collection of receivables, Warren is considering offering a cash discount of 2% if customers pay their bills within 10 days. The firm expects 50% of its customers to take the discount and its average collection period to decline to 30 days. The firm's required pretax return (i.e., opportunity cost) on receivables investment is 16%. Determine the net effect on Warren's pretax profits of offering a 2% cash discount.

Question

Quizplus · Accepted Answer

The net effect on pretax profits is calculated by considering the cost of the discount and the savings from reduced receivables. The cost of the discount is 0.02 * 0.5 * $30 million = $300,000. The reduction in receivables investment is calculated by the change in the average collection period: (48 - 30) / 365 * $30 million * 0.16 = $236,712. The net effect is $236,712 - $300,000 = -$63,288.

Warren Motor Company Sells $30 Million of Its Products to Wholesalers