Question 1

Hitech plc is an Irish based firm that specialises in the manufacture of components for a wide variety of electronic devices. Over the past year the firm has undertaken a number of marketing strategies in an attempt to increase its sales, but these strategies have largely been ineffective. As a member of the finance department, John Murphy has been tasked with assessing whether or not a change in the terms of credit offered to customers could achieve the firms sales growth objectives.

Currently the firm offers credit terms of net 30 to all its customers, resulting in annual credit sales of 24m, an average collection period of 34 days and a bad-debt loss ratio of 2%. After consultation with the marketing manager, John believes that changing the terms of credit to offer a cash discount to early-paying customers whilst offering other customers a longer period of credit would increase annual credit sales by 20%. The new terms of credit would be 4 / 10, net 60, with the bad-debt loss ratio increasing to 6% for those customers not availing of the discount (there would be no bad debts in respect of early-paying customers). Average collection periods would likely be 7 days for early-paying customers and 70 days for all other customers. It is estimated that 55% of sales would be subject to the discount.

Having also consulted with the production and purchasing managers, John believes there will be a knock-on effect in relation to the firms stock and creditors conversion periods. The current stock conversion period of 30 days would likely increase to 45 days, whilst the current creditors conversion period of 32 days would likely increase to 40 days. The firms cost of goods sold is currently 75% of sales, but due to inefficiencies that would likely creep in with the increased level of production, this ratio would likely increase to 78%. The firm has a pre-tax required return of 15% for investment in working capital.

Required:

Undertake a cost-benefit analysis of the proposed change in credit terms and advise whether or not the new credit terms should be adopted. Work to the nearest 0.01m at all times and show all your workings.