Case Study (6-13) Chapter 6 Accounts Receivable Managament

Jutawan Corporation is considering relaxing its current credit policy. Currently, the firm has
annual credit sales of RM7 million and an average collection period of 30 days. Under the
proposed change the credit term, would be changed from net 30 to net 90 and credit would be
extended to a riskier class of customer. It is assumed that bad debt losses on current customers
will remain at their current level. Under this change, it is expected that sales will increase by
RM8 million. Assume that the firm works 360 days a year. Given the following information,
should the firm adopt the new policy?
New sales level
Original sales level
Contribution margin
% bad debt losses on additional sales
New average collection period
Original average collection period
Additional investment in inventory
Pre-tax required rate of return
New Cash Discount

RM15 Million
RM7 Million
20%
7%
90 days
30 days
RM50,000
15%
0%

Solution:
Step 1: Estimate the change in profit
Y= (

S x CM) (

BD)

= [(15,000,000 7,000,000 x 0.2) ( 8,000,000.00 x 7%)]

= 1,600,000 560,000
= RM 1,040,000
Step 2: Estimate the cost of additional investment in accounts receivable and inventory
i) Additional accounts receivable =
[(New Sales Level)(New Average Collection)] [(Original Sales Level)(Original Average Collection)]
360
Period
360
Period
=[(15,000,000)(90)] [(7,000,000)(30)]
360
360
= 3,750,000 583,333.33
= RM 3,166,666.67

ii) Additional Inventory = RM50,000.00

iii) Pre-tax required rate of return = 15%
iv) Cost of Additional investment in accounts receivable and inventory =
(Additional accounts receivables + additional inventory) x (pre-tax required rate of return)
= ( RM3,166,666.67 + RM50,000) x 15%
= RM482,500
Step 3: Estimate the change in cost of the cash discount (if a change in the cash discount is
enacted)
Cash Discount = 0%
Step 4: Compare the incremental revenues with the incremental cost
Net change in pre-tax profits = Step 1 (Step 2 + Step 3)
Net change in pre-tax profits = RM1,040,000 (RM482,500 + 0)
= RM557,500
Conclusion:
Since the net change in pre-tax profits is of positive value, it is reasonable for the firm to adopt
the new policy.