4.Norton Wrench, a machine tool company, recently found out that one of its main competitors has tightened its credit standards. Nortons chief operating officer has asked you to make a recommendation to the executive policy committee on whether the company should tighten its standards. The marketing department estimates that annual sales will drop $20,000 from the present level of $275,000. The variable cost ratio is 0.7 and will not change, according to one of the cost accountants. Variable expenses related to collections and credit administration are projected at 1.25 percent of sales under the existing standards but 1.45 percent of sales under the proposed standards. The bad debt expense rate on both existing and incremental (lost) sales is estimated to be 7 percent. The DSO of 56 days is not expected to change and can be applied to any sales gained or lost due to a change in credit standards. The companys annual cost of capital is 15 percent.

Norton Wrench - credit standards tightening.

Current Proposed

Terms (E) Terms (N)

Sales per 365-day year $275,000 $255,000

Sales per day, S $753.42 $698.63

Sales growth rate, g -7.27%

Up-front Variable Cost Ratio (VCR) 70.00% 70.00%

Collection expenses (EXP) at DSO 1.25% 1.45%

Bad debt expense ratio, b , at DSO 7.00% 7.00%

Discount percent, d 0 0

Discount period, days 0 0

Proportion taking discount, p 0 0

Non-discount period, days 56 56

k = company's annual nominal cost of capital 15%

i = daily cost of capital 15% / 365 = 4.1096%

Note: an annual nominal cost of 15% compounded daily implies an annual effective cost of { [ (1 + .15/365)^365 ] - 1 } * 100 = 16.18% per year.

a.Draw a cash flow timeline for 1 days sales under existing credit policy

b.What is the value effect (Z) of this decision on 1 days sales?

c.What is the overall value effect (NPV)?

d.Are there any nonfinancial considerations about which you believe the executive policy committee should be warned?