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Chapter 3: 20BP_a (page 224)

Slow Roll Drum Co. is evaluating the extension of credit to a new group of customers. Although these customers will provide \(180,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur \)16,200 in additional collection expense. Production and marketing costs represent 72 percent of sales. The firm is in a 34 percent tax bracket. No other asset build-up will be required to service the new customers. The firm has a 10 percent desired return. Assume the average collection period is 120 days.

a. Compute the return on incremental investment.

Short Answer

Expert verified

The return on incremental investment is 7.92%.

Step by step solution

01

Information provided in the question

Increase in sales = $180,000

Production and marketing costs = 72%

Uncollectible accounts = 15%

Collection costs = $16,200

Income taxes = 34%

Accounts receivables turnover = 4 times

02

Calculation of incremental income after taxes

The incremental income after taxes is $4,752.

Particulars

Amount

Additional sales

$180,000

Accounts uncollectible (12% of additional sales)

($27,000)

Annual incremental revenue

$153,000

Collection costs

($16,200)

Production and marketing costs (72% of additional sales)

($129,600)

Annual income before taxes

$7,200

Taxes (34%)

($2,448)

Incremental income after taxes

$4,752

03

Calculation of accounts receivables

The accounts receivables is $60,000.

Accountsreceivables=Averagecollectionperiod×Averagedailysales=120×$180,000360=120×$500=$60,000

04

Calculation of incremental after-tax return on investment

The incremental after-tax return on investment is 7.92%.

Incrementalafter-taxreturnoninvestment=IncrementalincomeInvestmentinreceivables×100=$4,752$60,000×100=7.92%

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