PEL Company has annual sales revenue of Rs. 10 million. It has a contribution to sales ratio of 45% and its annual fixed costs are Rs. 4.5 million. These figures exclude bad debts which are currently 1.25% of sales. All sales are on credit and standard credit terms are 30 days, although customers take on average 45 days to pay. Accounts receivable are financed by a bank overdraft on which interest is payable at 6%.

The companys management are considering whether to offer a discount of 2.5% for all customers who pay within 15 days, and to extend the credit period for other customers to 60 days. It has been estimated that if this policy is introduced, 25% of customers would take the settlement discount and the rest would take the full 60 days credit offered.

The new policy would result in higher administration costs equal to 1% of total gross sales. It is expected that total (gross) sales would be boosted and would increase by 5% per year. It is also expected that bad debts would fall to 1% of gross sales.

Required What is the effect of the new policy on annual profit and recommend whether the new policy should be introduced? Suggest an alternative policy for the management of receivables that might improve profit by a larger amount.