Relaxation of credit standards Lewis Enterprises is considering relaxing its cre
ID: 2788993 • Letter: R
Question
Relaxation of credit standardsLewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a result of the proposedrelaxation, sales are expected to increase by 20% from 12,000 to 14,400 units during the coming year; the average collection period is expected to increase from 30 to 50 days; and bad debts are expected to increase from 2.5% to 4% of sales. The sale price per unit is $ 37, and the variable cost per unit is $ 26 The firm's required return on equal-risk investments is 24.6%. Evaluate the proposed relaxation, and make a recommendation to the firm.(Note: Assume a 365-day year.)
Explanation / Answer
additional profit contribution from sales
= (14400-12000) * (37-26)
= 26400
average investment proposed plan = 14400 * 26/365/50 = 51287.67
average investment present plan = 12000 * 26/365/30 = 25643.84
margin investment in A/R = 51287.67 - 25643.84 = 25643.84
cost of margin investment in A/R = 25643.83 * 24.6% = 6308.38
cost of marginal bad debt proposed plan
= 4% * 37 * 14400 = 21312
cost of marginal bad debt present plan = 2.5% * 37 * 12000
= 11100
cost of marginal debts = 21312 - 11100
= 10212
net profit from implementing proposed plan
= 26400 - 6308.38 - 10212
= 9879.62
The credit standards should not be relaxed since the proposed plan results in a profit.