Dome Metals has credit sales of $270,000 yearly with credit terms of net 90 days, which is also the average collection period. Assume the firm adopts new credit terms of 2/15, net 90 and all customers pay on the last day of the discount period. Any reduction in accounts receivable will be used to reduce the firm's bank loan which costs 12 percent. The new credit terms will increase sales by 20% because the 2% discount will make the firm's price competitive.
a. If Dome earns 15 percent on sales before discounts, what will be the net change in income if the new credit terms are adopted?

Solution and Explanation:

Sales divide 360 days = average daily sales

$2700,000 divide 360 = $ 750

Accounts receivable balance

= $750 multiply 30 days   = $22,500

Receivable turnover

= sales divide receivables

= $270,000 divide $22500

= 12x

If Dome Metals were to offer a 2 percent discount for payment in 15 days and every customer took advantage of the new terms, what would the new average receivables balance be? Use the full sales of $2700,000 for your calculation of receivables.

$750 multiply 15 days = $11250 new receivable balance

If Dome Metals its bank loans, which cost 12 percent, by the cash generated from its reduced receivables, what will be the net gain or loss to the firm?

Old receivables – new receivables with discount = Funds freed by discount

  $ 22500         –        $11250                               = $11250  

     Savings on loan = 12% multiply $10,000       =       $ 1,350  

     Discount on sales = 2% multiply $270,000       =       (5,400)  

     Net change in income from discount                $(4,050)  

No! Don't offer the discount since the income from reduced bank loans does not offset the loss on the discount.