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Hi John .
Please help me with the foll. qn:
A company is proposing an increase in the credit period that it gives to customers from one month to one an a half month calendar months. The aim is to increase revenue. Current annual revenue – 24mn USD; 4m units each sold at 6$. Each unit costs 5.40 $ to make. The increase in the credit period is likely to generate 150,000 extra unit sales. Is this enough to justify extra costs given the company’s required rate of return is 20%.
The biggest problem i’m facing is what is the context of “…the company’s required rate of return is 20%..”
Thanks in adv
You would use the 20% in the same way as you would if they were paying 20% overdraft interest.
So the longer credit is effectively costing them interest, but the increased sales are earning them more profit.
They need to compare the extra profit from the goods with the extra interest involved to decide whether or not it was worth doing.You mean it can either be interest earned or interest payable. Like time value of money.
Isn’t this made in the two assumption that: the money is always supposed to be invested or if there is always supposed to be an overdraft. . .
If there is an overdraft then the cost is the overdraft interest.
If there is not an overdraft then the cost is the interest that is lost by having less to invest.Either way, it is still effectively a cost – whether you pay interest directly or whether you lose interest that you could have earned.
Hey John. Please help me. Is my answer correct.
A Co is considering increasing the period of credit form one calendar month to 2 months. Annual sales are currently 2.4m usd. Annual profits 120,000$. Extending credit would increase sales by 20%. Margins remain unchanged. Required rate of return 15%.
What is the financial effect of proposal?
I got decrease by 18000
Current receivables are 1/12 x 2.4M = 200,000
New receivables are 2/12 x (2.4M x 1.2) = 480,000So the extra interest cost = (480,000 – 200,000) x 15% = 42,000
The extra profit = 20% x 120,000 = 24,000.
So there is a decrease of 42,000 – 24,000 = 18,000.
So your answer is correct 🙂 🙂
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