(^256) Financial Management
c. Suppose the credit policy change will also reduce sales by Rs 5,000 per day.
What would be the company's investment in accounts receivable? What will
be the expected effect of this policy change on the company's after-tax net
income?
Solution
a. The average balance of accounts receivable is:
Average A/R balance = (Rs 620,000/day) (50 days) = Rs 31,000,000
Average investment in A/R =(Rs 31,000,000) (0.80) = Rs 24,800,000
The cost of financing the investment in receivables is:
Cost of financing A/R = (Rs 24,800,000) (.09) = Rs 2,232,000
Note: The financing cost of carrying receivables is based on the cost of sales
since the cost of sales represents the cash paid out in advance of collections. The
cash paid out creates a financing need.
b. Reducing the collection period by 4 days will free up:
Cash freed up = (4days) (Rs 620,000 per day) (0.80) = Rs 1,984,000
The net advantage is reduced financing cost of the cash freed up:
Reduced financing cost = (Rs 1,984,000) (0.09) = Rs 178,560 per year
c. If sales decrease and the average collection period is reduced,
New investment in A/R=(Rs 615,000)(0.80)(46) Rs 22,632,000
New financing cost of A/R=(Rs 22,632,000)(0.09) = Rs 2,036,880
There are two effects on sales:
D Financing cost of A/R=(Rs 2,232,000-Rs 2,036,880) Rs 195,120
D Net Profit from lower sales=(-Rs 5,000/day)(365)(0.20)(0.60) 219,000
D NIAT -Rs 23,880
Note: Here D means additional
Given the expected effects, the policy change would not be profitable.
- Rupesh Goel, credit manager of Kalpana Company, is considering a change in the
company's credit terms from net 60 to net 30. Kalpana has daily credit sales of
Rs 50,000 and its variable cost ratio is 15 percent. Tightening credit standards
would reduce the average collection period from 75 days to 40 days, reduce daily
sales by Rs 2,000, and lower bad debts from 5 percent of sales to 3 percent of
sales. The company's marginal tax rate is 40 percent and it uses an after-tax