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Optimal level of Accounts Receivable

Acme Batteries currently offers credit terms of 2/10, n30, and Sarah, the vice president for
marketing, thinks the terms should be changed to 2/10, n40. Doing so, she says, will result in a
10% increase in sales, but only a small increase in bad debts. Should Acme make the change?
For the sake of simplicity, following assumptions are considered:

Ms. Sarah is correct that sales will increase by 10% if the new credit policy is
implemented.
Cost of goods sold and other operating expenses on the firms income statement, and all
current accounts on the balance sheet, will vary directly with sales. So each of these
accounts will increase by 10% with the change in credit policy.
All of Acmes sales are made on credit.

Suppose further that Ms. Sarah produced the following data on Acmes customers historical
payments:

45% of customers take advantage of the discount and pay off their accounts in 10 days.
53% of customers forgo the discount, but pay off their accounts in 30 days.
The remaining 2% of customers pay off their accounts in 100 days.

Ms. Sarah expects that under the new credit policy (2/10, n40):

45% of customers will take advantage of the discount and pay off their accounts in 10
days.
52% of customers will forgo the discount, but pay off their accounts in 30 days.
The remaining 3% of customers will pay off their accounts in 100 days.

Acmes CFO has informed that any increases in current assets resulting from the policy change
will be financed from short-term notes at an interest rate of 6%. He has also informed that the
firms effective tax rate is 40%, and that the cost of capital is 10%. The long-term interest rate is
8%. You are required to tell Ms. Sarah whether the new credit policy is worth accepting or not.
Following data from the income statement and balance sheet are given.

Sales
CGS
Gross Profit
Bad Debt Expenses
Other Operating Expenses
Operating Income
Interest Expense
EBT
Income Tax
Net Income

Old Credit Terms (2/10, n30)


$201734
107280

43229

Old Credit Terms (2/10, n30)


Assets
Cash & Marketable Securities
Accounts Receivable
Inventory
Total Current Assets
Property, Plant, & Equipment
Total Assets
Liabilities & Equity
Accounts Payable
Notes Payable
Total Current Liabilities
Long-term Debt
Total Liabilities
Common Stock
Capital in Excess of Par
Retained Earnings
Total Stockholders' Equity
Total Liabilities & Equity
Additional Funds Needed

$65313
21453
92983

26186
302
15034
35000
32100
83507
150607

Optimal level of Inventory


Dealin Dan, the owner of Cream Puff Used Cars, wants to determine the optimal number of cars
to display on his lot. Dan knows that increasing the number of cars on display will probably
cause sales to increase, but would also increase his inventory carrying costs. Dan also knows that
decreasing the number of cars on display will save him inventory cost but might also cost him
sales. As a result, Dan is not sure how a change in his planned average inventory level from 32
cars to 48 cars will affect the value of the firm.
Following assumptions are considered about Cream Puffs financial condition:

Cream Puffs inventory ordering costs are $100 per order.


Inventory carrying costs are $500 per car per year.
Because Dan does not expect to keep cars on the lot more than a few weeks, he finances
all the firms inventory with short-term debt. The short-term interest rate available to
Cream Puff is 6%.
Cream Puff pays $5000, on average, for each car it produces for resale. The firms
average selling price per car is $6000.
Cream Puff displays, on average, about 32 cars on its lot. Sales occur regularly
throughout the year, and Dan expects to sell 200 cars this year.
Based on his previous experience, Dan believes that the relationship between inventory
and Cream Puffs car sales is direct and he expects that an increase in inventory from 32
to 48 cars should produce an increase in the number of cars sold per year from 200 to
232.
Dan uses economic order quantity (EOQ) model to compute the number of cars to order
from wholesale dealers when he replenishes his inventory.
Operating expenses on Cream Puffs income statement and all current accounts on the
balance sheet vary directly with the sales, so each of these accounts will increase (or
decrease) proportionally with sales.
Assume the interest rate on short-term debt is 6% and the rate on long-term debt is 8%.
Effective tax rate is 40%, and the firms cost of capital is 10%.

You are required to tell Dan whether the new inventory policy is worth accepting or not.
Following data from the income statement and balance sheet are given.
Current Inventory Policy
Sales
CGS
Gross Profit
Inventory Costs
Other Operating Expenses
Operating Income
Interest Expense
EBT
Income Tax
Net Income

85000

Current Inventory Policy


Assets
Cash & Marketable Securities
Accounts Receivable
Inventory
Total Current Assets
Property, Plant, & Equipment
Total Assets
Liabilities & Equity
Accounts Payable
Notes Payable
Total Current Liabilities
Long-term Debt
Total Liabilities
Common Stock
Capital in Excess of Par
Retained Earnings
Total Stockholders' Equity
Total Liabilities & Equity
Additional Funds Needed

47000
63000

72000

50000
74000
124000
45000
169000
35000
34000
104000
173000