Boswell Enterprises Ltd. is reviewing its credit policy. The business, which sells all of its goods on credit, has estimated that sales revenue for the forthcoming year will be $3 million under the existing policy; 30% of accounts receivable are expected to be collected one month after being invoiced and 70% are expected to be collected two months after being invoiced. These estimates are in line with previous years' figures.
At present, no cash discounts are offered to customers. However, to encourage prompt payment, the business is considering giving a 2.5% cash discount to customers who pay in one month or less. Given this incentive, the business expects 60% of receivables to be collected one month after being invoiced and the remaining amounts two months after being invoiced. The business believes that the introduction of a cash discount policy will prove attractive to some customers and will lead to a 5% increase in total sales revenue.
The gross profit margin of the business will remain at 20% for the forthcoming year and three months' inventory will be held. Fixed monthly expenses of $15,000 and variable expenses (excluding discounts) equivalent to 10% of sales revenue will be incurred and will be paid one month in arrears. Accounts payable will be paid in arrears and will be equal to two months' cost of sales. The business will hold a fixed cash balance of $140,000 throughout the year, whichever trade credit policy is adopted. No dividends will be proposed or paid during the year. Ignore taxes.
Required:
(a) Calculate the investment in working capital at the end of the forthcoming year under:
(i) The existing policy
(ii) The proposed policy.
(b) Calculate the expected net income for the forthcoming year under:
(i) The existing policy
(ii) The proposed policy.
(c) Advise the business as to whether it should implement the proposed policy.