The Boca Grande Company expects to have sales of $10 millions this year under its current operating policies. Its variable costs as a percentage of sales are 80%, and its required rate of return is 16%. Currently Boca Grande’s credit policy is net 25 (no discount for early payment). However its DSO is 30 days and its Bad debt loss percentage is 2%. Boca Grande spends $50,000 per year to collect bad debts and its marginal tax rate is 40%.
The credit manager is considering two alternative proposals for changing Boca Grande’s credit policy. Find the expected change in net income, taking into consideration anticipated changes in carrying costs for accounts receivable, the probable bad debt losses and its discount likely to be taken for each proposal. Should a change in credit policy be made?
Proposal 1: Lengthen the credit period by going from net 25 to net 30. collection expenditures will remain constant. Under this proposals sales are expected to increase by $1 million annually, and the bad debt loss percentage on new sales is expected to rise to 4%.(the loss percentage on old sales should not change) . In addition, the DSO is expected to increase from 30 to 45 days on all sales.
Proposal 2: Shorten the credit period by going from net 25 to 20. Again collection expenses will remain constant. The anticipated effects of this change are a decrease in sales of $1 million per year, a decline in the DSP from 30 to 22 days and a decline in the bad debt loss percantage to 1% on all sales.