Covers, Inc. (CI) sells its stainless steel products on terms of "2/10, net 40". CI is considering granting credit to retailers with total assets as low as $500,000. Currently the lowest asset limit is $750,000. CI believes sales will increase $7 million from the new credit group but the average collection period for this new group will be 60 days versus the current average collection period of 35 days. If management estimates that 20% of the new customers will take the cash discount but 4% of the new business will be written off as a bad-debt loss, should CI lower its credit standards? Assume CI's variable cost ratio is 0.7 and its required pretax rate of return on receivables investment is 15%.

Question

Quizplus · Accepted Answer

Solution:
Profit on new sales = $7,000,000(1 - 0.7) = $2,100,000
Cost of new rec. = ($7,000,000/365)(60)(0.15) = $172,603
Cost new bad debt losses = $7,000,000(0.04) = $280,000
Additional cash discounts = 7,000,000(0.20)(0.02) = $28,000
Net change in pretax profit = $1,619,397