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A company is considering increasing its credit period to customers from one month to two months. Annual revenue is currently $1,2000,000. It is expected that the increased credit period would increase sales by 25% and result in an increase of profit of 45,000,before any INCREASE in finance charges have been taken into account. The company’s cost of capital is 10%.
What is the financial eff left if this proposal, after taking into account any increase in finances charges ?
A increase in forifit $35,000
B decrease in profit of $35,000
C increase in profit of $30;000
D decrease in profit of $30,000Nerissa, how do you think you should approach this question? Which part are you stuck on?
A couple of weeks ago you were struggling with a similar question, I gave you the answer and explained the method I used to get there. I could solve the question for you again, but that won’t help you learn to do it yourself.
I’ll give you a hint. Think about the effect that this change of policy will have on the company’s level of receivables, and what that will mean for profits?
I am solving the questions but I just don’t think that I understand I am constantly second guessing doing the entire question with uncertainty which means that I really do not understand; I am afraid of going into the exam filled with doubt.
I got an over all increase of $30,000, well pretty much guessed that answer. Based what I worked out but I believe my biggest struggle is figuring out which figure should I take the cost of capital from.
So I said since the change reflects and increase it means that the company needs more working capital to finance daily activities since most of the companies cash would still be owed.
Thus already proven via new policy is receipt of $45,000 in profit
Currently receivables is 1,200,000/12 months =$100,000
New policy would now go to two months thus 12/2=6 so $1,200,000 /6 * 25% =$250000
The difference between these two is and increase of 150,000So this is where I was confused should I take the cost of capital from this 150,000 or from $250,000
But I decided to take it from the $150,000 got $15000 then subtracted from the $45,000 to get my answer
The cost of capital always has to be multiplied by the level of working capital held to calculate the effect on profit.
Therefore in this question you will need to calculate what the current level of receivables is, and what it will be if the proposal goes ahead.
You must have posted while I was typing my post, but your approach is correct and you’ve got the right answer!
It’s the difference in profit between the old policy and the new policy that you need to calculate, so it’s the difference between the old level of receivables and the new level, multiplied by the cost of capital.
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