The Bimbo Corporation has been experiencing a decline in sales relative to its major competitors. Because Bimbo is confident about the quality of its products, it suspects that this sales loss may reflect its relatively stringent credit standards and terms. The firm currently has credit sales of $50 million annually. With current credit terms of “net 20,” its average collection period is now 25 days. Bad-debt losses are 2 percent of credit sales. The firm’s variable cost ratio is 0.80, and its required pretax return on receivables and inventory investments is 20 percent.
Bimbo plans to change its credit terms to “2/10, net 30.” It expects 20 percent of its customers to take advantage of the cash discount. Bimbo also plans to relax credit standards and take on riskier accounts. This action is expected to increase credit sales by 30 percent. Bad-debt losses are expected to increase to 3 percent of credit sales, and the average collection period is expected to become 30 days. The company also estimates that an additional investment in inventory of $3 million is required because of the anticipated sales increase. Determine the net effect of this plan on the pretax profits of Bimbo.