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Hi John. Please help me with this qn.
Lowe and Price Co has annual credit sales of 12m$ and three months are allowed for payment. The company decides to offer a 2% discount for payments made within 10 days of the invoice being sent, and to reduce the maximum time allowed for payments to 2 months. It is estimated that 50% of customers take the discount. If the company requires 20% return on investment, what will be the effect of the discount?
The ans is 247,123$ (net benefit of introducing discount policy)
I cant seem to arrive at this answer
I am surprised that your book does not show the workings!!
The cost of the discount is 2% x 12M x 0.5 = 120,000 per year.
The current collection period is 90 days (if we assume 30 days in a month).
The new average collection period is (10 + 60) / 2 = 35 days (again, assuming 30 days in a month).So a saving of 90 – 35 = 55 days.
The interest saving is therefore 55/360 x 20% x 12M = 366,667
Giving a net saving of 366,667 – 120,000 = 246,667
I don’t know why the answer given is different – maybe they have assumed different number of days in months or years. However, in the real exam, unless you were given more detail then my answer would get full marks (and usually it would only be asked for to the nearest thousand anyway 🙂 )
Hi John. The way they’ve done it as is follows:
“Our approach is to calculate the profits forgone by offering the discount and the interest charges saved or incurred as a result of the changes in the cash flows of the company.
a. The volume of accounts receivable, if the company policy remains unchanged , would be:
3/12 x $12m = 3m$
b) If policy changed, the a/receivable would be:
(10/365 x50% x 12m$) + (2/12 x 50% x 12m$) = 1,164,384$
c) There will be a reduction in a/receivable of $1,835,616
d) The company can invest 20% a year so 0.2 x 1835616 = 367,123$
Finally, 367,123 – 120,000 = 247,123$
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The problem i am facing is from part b) which says that the “ac receivable would be..etc…
The a.c receivable in b) should be 1,164,384 minus the discount allowed which is 120,000 = 1,044,384. (This is the true a/c receivable)
Then took it and multiplied 20%= 208,876$
Why i am wrong john?
Two things
First (and I know that you are not asking this 🙂 ) the reason their answer is slightly different from mine is that they assume 365 days in a year. However in the exam they will make it clear what to assume. (They show their workings differently, but that does not matter at all).
Secondly, in relation to what you have actually asked, there are arguments for and against subtracting the discount from the receivables. For that reason, the examiner has always accepted either way. (The difference in the final result is only ever fairly small, which is why he usually asks for the answer to the nearest thousand)
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