RCMP has annual credit sales of $37 million. The credit terms are "net 30," and the current average collection period is 45 days. RCMP is considering changing its terms to "1/10, net 30" in an effort to reduce the average collection period. RCMP believes that 35% of its customers will take the discount, reducing the average collection period to 33 days. Should RCMP offer the discount? Why or why not? Assume the firm's required rate of return on its receivables investment is 14%.

Question

Quizplus · Accepted Answer

To calculate the impact of offering the discount, we need to compare the present value of the cash flows under the current terms to the present value of the cash flows with the new terms.

Under the current terms, the average collection period is 45 days, which means that on average RCMP receives payment 15 days after the due date. Using a 365-day year, the effective annual interest rate on the receivables is:

EAR = (1 + (30/15))^((365/45)-1) - 1 = 24.93%

The present value of the cash flows under the current terms is:

PV = 37,000,000 / (1 + 0.2493/365) = 34,972,402.17

Under the new terms, 35% of customers will take the discount, which means that RCMP will receive payment on day 10. The remaining 65% of customers will pay on day 30. The effective annual interest rate on the receivables is:

EAR = (1 + (30-10)/10)^((365/33)-1) - 1 = 42.08%

The present value of the cash flows under the new terms is:

PV = (0.35 x 37,000,000 x 0.99 / (1 + 0.4208/365)) + (0.65 x 37,000,000 / (1 + 0.4208/365)) = 35,013,203.08

The incremental cash flows from offering the discount are:

ICF = 35,013,203.08 - 34,972,402.17 = 40,800.91

The pretax profits will increase by the amount of the incremental cash flows multiplied by the required rate of return:

Pretax profits = 40,800.91 x 0.14 = $5,712.13

Therefore, RCMP should offer the discount, and the correct answer is C) Yes; pretax profits increase $40,801.

RCMP Has Annual Credit Sales of $37 Million