Financial ManagementTU Board 2023
Delta Metal House (DMH) is considering changing its credit terms from net 40 to net 50, in order to increase sales. Past average collection period is 60 days and it will be 75 days under proposed…
5Delta Metal House (DMH) is considering changing its credit terms from net 40 to net 50, in order to increase sales. Past average collection period is 60 days and it will be 75 days under proposed plan. The change will also affect in the present percent level of bad debt to 2 percent on all sales. Due to change in credit terms it is expected to increase in sales from Rs 6 million to Rs 7.5 million per year. The variable cost ratio is 80 percent, the cost of funds invested in accounts receivable is 12 percent and the marginal tax rate is 30 percent. Should the DMH change its credit terms?
Answer
Analysis of Credit Terms Change for BTC
1. Calculate Incremental Sales Revenue
- Current sales = Rs 6,000,000
- Proposed sales = Rs 7,200,000
- Incremental sales = Rs 1,200,000
2. Variable Costs (70%)
- Incremental variable cost = 70% × Rs 1,200,000 = Rs 840,000
3. Bad Debt Increase
- Current bad debt = 2% of Rs 6,000,000 = Rs 120,000
- Proposed bad debt = 2.5% of Rs 7,200,000 = Rs 180,000
- Increase in bad debt = Rs 60,000 (Note: Only the additional bad debt of Rs 36,000 is relevant for incremental analysis, as the original Rs 120,000 was already accounted for in current operations.)
4. Tax Impact (30%)
- Incremental profit before tax = Rs 1,200,000 (sales) – Rs 840,000 (costs) – Rs 36,000 (additional bad debt) = Rs 324,000
- Tax = 30% × Rs 324,000 = Rs 97,200
5. Opportunity Cost of Funds in Accounts Receivable (AR)
- Current AR turnover = 365 / 45 days = 8 times/year
- Proposed AR turnover = 365 / 60 days = 6 times/year
- Average AR under current policy = Rs 6,000,000 / 8 = Rs 750,000
- Average AR under proposed policy = Rs 7,200,000 / 6 = Rs 1,200,000
- Increase in AR = Rs 1,200,000 – Rs 750,000 = Rs 450,000
- Opportunity cost (10%) = 10% × Rs 450,000 = Rs 45,000 (Note: The correct incremental AR calculation should consider only the change in AR due to the increase in sales, not the entire AR. The proper method is to calculate the additional funds tied up due to slower collection.)
Correct Calculation of Additional Funds Tied Up in AR:
- Current AR days = 45, Proposed AR days = 60
- Incremental sales = Rs 1,200,000
- Additional AR = (60 – 45) days × (Rs 1,200,000 / 365) = 15 × 3,287.67 ≈ Rs 50,000
- Opportunity cost (10%) = 10% × Rs 50,000 = Rs 5,000
6. Net Cash Flow Impact
| Component | Amount (Rs) |
|---|---|
| Incremental Sales Revenue | +1,200,000 |
| Less: Variable Costs | -840,000 |
| Less: Additional Bad Debt | -36,000 |
| EBIT | 324,000 |
| Less: Tax (30%) | -97,200 |
| Net Operating Benefit | 226,800 |
| Less: Opportunity Cost (AR) | -5,000 |
| Net Cash Flow Impact | Rs 221,800 |
Conclusion
Since the net cash flow impact (Rs 221,800) is positive, BTC should change its credit terms from 'net 40' to 'net 50' to increase sales, despite the trade-off in higher bad debts and slower collections. The increase in profitability outweighs the additional financing cost.
Discussion
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