Accountancy Test Questions

Collins Office Supplies is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 5 percent of new sales, production and selling costs are 78 percent, and accounts receivable turnover is five times. Assume income taxes of 30 percent and an increase in sales of $80,000. No other asset buildup will be required to service the new accounts.
a. What is the level of accounts receivable needed to support this sales expansion?
Investment in Accounts receivables = 80,000/ 5 = $16,000
b. What would be Collins’s incremental aftertax return on investment?

Particulars
Amount
Increase in sales
80,000
Less Accounts uncollectible (9% of 80,000 new sales)
-7,200
Annual incremental revenue
72,800
Less collection costs (5% of 80,000 new sales)
-4,000
Less production and selling costs (78% of 80,000)
-62,400
Annual income before taxes
6,400
Less Taxes (30%)
-1920
Incremental income after taxes
4,480
Return on incremental investment = 4,480/ 16,000 = 28%
c. Should Collins liberalize credit if a 15 percent aftertax return on investment is required? Assume Collins also needs to increase its level of inventory to support new sales and that inventory turnover is four times.
Yes, Collins should liberalize the credit policy as the return on investment is 28% which is more than the required rate of return is 15%.

d. What would be the total incremental investment in accounts receivable and inventory to support an $80,000 increase in sales?
Investment in inventory = 80,000 / 4 = $20,000

Incremental investment :
Inventory 20,000
Accounts receivables 16,000 Total incremental investment 36,000

Return on incremental investment = 4,480/ 36,000 = 12.44%

e. Given the income determined in part b and the investment determined in part d, should Collins extend more liberal credit terms?
No, Collins should not extend more liberal credit