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Finance 11

Nelson Corporation is considering easing its credit standards which could increase annual sales by 25% but also increase bad debt losses and collection costs. If implemented, sales would rise by $2.5 million but bad debts would increase by $280,000 and costs by $34,000 and $665,000. However, the net advantage to Nelson Corporation would still be $1,521,000, so relaxing credit standards would be beneficial.

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1K views2 pages

Finance 11

Nelson Corporation is considering easing its credit standards which could increase annual sales by 25% but also increase bad debt losses and collection costs. If implemented, sales would rise by $2.5 million but bad debts would increase by $280,000 and costs by $34,000 and $665,000. However, the net advantage to Nelson Corporation would still be $1,521,000, so relaxing credit standards would be beneficial.

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Nelson Corporation reports the following information:

Selling price per unit $70


Variable cost per unit $45
Fixed cost per unit $15
Annual credit sales 400,000 units
Collection period 3 months
Rate of return 19%

The company is considering easing its credit standards. If it does, the following is expected
to result:

Sales will increase by 25%;


collection period will increase to 4 months;
bad debt losses are anticipated to be 4% on the incremental sales;
and collection costs will increase by $34,000.

Should the proposed relaxation in credit standards be implemented?


Support your answer with computations.

Solution:

Incremental Profit:
Increased unit sales (400,000 x 0.25) 100,000
Contribution margin per unit ($70 - $45) x $25
Incremental profit $ 2,500,000

Increased bad debts:


Incremental dollar sales (1000,000 x $70) $ 7,000,000
Anticipated bad debt losses percentage x 0.04
Additional bad debts $ 280,000

New average unit cost:

Units Unit Cost Total Cost


Present 400,000 $ 60 $ 24,000,000
Increment 100,000 $ 45 4,500,000
Total 500,000 $ 28,500,000

New average unit cost = $ 28,500,000 = $ 57


500,000

Additional Cost:

Investment in average accounts receivable


[(credit sales/turnover) x (unit cost/selling price)]
After change in policy
[($35,000,000/3) x ($57/$70)] $ 9,500,000
Current
[($28,000,000/4) x ($60/$70)] 6,000,000
Incremental $ 3,500,000
Rate of return x 0.19
Opportunity cost $ 665,000

Net advantage or disadvantage of proposal:

Additional profitability $ 2,500,000


Less: Increased bad debts $ 280,000
Increased collection cost 34,000
Opportunity cost 665,000 979,000
Net Advantage $ 1,521,000

It is in the best interest of Nelson Corporation to implement its proposed relaxation of credit
standards as it can gain a net advantage of $ 1,521,000.00.

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