ARMCLIFF Co.

Armcliff Co is a division of Shevin Inc., which requires each of its divisions to achieve a rate of return on capital employed of at least 10% pa. For this purpose, capital employed is defined as fixed capital and investment in inventories. This rate of return is also applied as a hurdle rate for new investment projects. Divisions have limited borrowing powers and all capital projects are centrally funded. The following is an extract from Armcliff’s divisional accounts: Statement of profit or loss for the year ended 31 December 20X4 $m Sales revenue 120 Cost of sales (100) –––– Operating profit 20 –––– Assets employed as at 31 December 20X4 $m $m Non?current assets (NBV) 75 Current assets (including inventories $25m) 45 Current liabilities (32) ––– 13 ––– Net capital employed 88 ––– Armcliff’s production engineers wish to invest in a new computer?controlled press. The equipment cost is $14m. The residual value is expected to be $2m after four years operation, when the equipment will be shipped to a customer in South America. The new machine is capable of improving the quality of the existing product and also of producing a higher volume. The firm’s marketing team is confident of selling the increased volume by extending the credit period. The expected additional sales are: Year 1 2,000,000 units Year 2 1,800,000 units Year 3 1,600,000 units Year 4 1,600,000 units Sales volume is expected to fall over time due to emerging competitive pressures. Competition will also necessitate a reduction in price by $0.50 each year from the $5 per unit proposed in the first year. Operating costs are expected to be steady at $1 per unit, and allocation of overheads (none of which are affected by the new project) by the central finance department is set at $0.75 per unit. Higher production levels will require additional investment in inventories of $0.5m, which would be held at this level until the final stages of operation of the project. Customers at present settle accounts after 90 days on average. REQUIRED: Briefly discuss the dangers of offering more generous credit. ANSWER: Armcliff intends to achieve a sales increase by extending its receivables collection period. This policy carries several dangers. It implies that credit will be extended to customers for whom credit is an important determinant of supplier selection, hinting at financial instability on their part. Consequently, the risk of later than expected, or even no payment, is likely to increase. Although losses due to default are limited to the incremental costs of making these sales rather than the invoiced value, Armcliff should recognise that there is an opportunity cost involved in tying up capital for lengthy periods. In addition, companies which are slow payers often attempt to claim discounts to which they are not entitled. Armcliff may then face the difficult choice between acquiescence to such demands versus rejection, in which case, it may lose repeat sales. MY QUERY: How are we supposed to know that Armcliff intends to achieve a sales increase or even that it is extending its receivables' collection period? This information is not provided in the question.