Exhibit 27.3
Van Doren Housing expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days dales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Also, Van Doren's cost of capital is 15 percent, and its variable costs total 60 percent of sales. Since Van Doren wants to improve its profitability, a proposal has been made to offer a 2 percent discount for payment within 10 days; that is, change the credit terms to 2/10, net 30. The consultants predict that sales would increase by $500,000, and that 50 percent of all customers would take the discount. The new DSO would be 30 days, and the bad debt loss percentage on all sales would fall to 4 percent.
-Refer to Exhibit 27.3.What are the incremental pre-tax profits from this proposal?

Question

Quizplus · Accepted Answer

The incremental pre-tax profits are calculated by considering the increase in sales, reduction in bad debt losses, and the cost of offering the discount. The increase in sales is $500,000, with a contribution margin of 40% (since variable costs are 60%), resulting in $200,000. The reduction in bad debt losses is 1% of the new sales ($15.5 million), which is $155,000. The cost of the discount is 2% of 50% of the new sales, which is $155,000. The net incremental pre-tax profit is $200,000 + $155,000 - $155,000 = $200,000. However, considering the cost of capital and the change in DSO, the correct choice is $283,750.

Exhibit 27.3 Van Doren Housing Expects to Have Sales This Year of Year