The United Shoe Company (USC) does not extend credit to any retail shoe store with a "Fair" or "Limited" Dun and Bradstreet credit rating. Because of this policy, the company loses $36,500,000 in sales each year. Based on prior experience with these types of customers, USC estimates that the average collection period would be 120 days and the bad-debt loss ratio would be 10%. The firm's variable cost ratio is 0.75. USC's required pretax return on receivables investments is 18%. Determine the net change in pretax profits of extending credit to these retail shoe stores. (Assume 365 days per year in any calculations.)
A) $9,125,000
B) $3,315,000
C) -$1,095,000
D) $2,160,000

Question

Quizplus · Accepted Answer

First, calculate the additional sales revenue USC would gain by extending credit: $36,500,000. The variable cost ratio is 0.75, so the variable costs associated with these sales would be $36,500,000 * 0.75 = $27,375,000. The contribution margin from these sales, therefore, would be $36,500,000 - $27,375,000 = $9,125,000.Next, calculate the bad-debt loss, which is 10% of the sales: $36,500,000 * 0.10 = $3,650,000. Subtracting this from the contribution margin gives $9,125,000 - $3,650,000 = $5,475,000.To find the net change in pretax profits, we also need to consider the cost of financing the receivables. The average collection period is 120 days, so the average investment in receivables would be ($36,500,000 / 365) * 120 = $12,000,000. The required pretax return on this investment is 18%, so the cost of financing is $12,000,000 * 0.18 = $2,160,000.Subtracting the cost of financing from the adjusted contribution margin gives the net change in pretax profits: $5,475,000 - $2,160,000 = $3,315,000.

The United Shoe Company (USC) Does Not Extend Credit to Any