In the effort to speed up the collection of receivables, Hill Publishing Company is considering increasing the size of its cash discount by changing its credit terms from 1/10, net 30 to 2/10, and net 30. Currently, the company’s collection period averages 43 days. Under the new credit terms, it is expected to decline to 28 days. Also, the percentage of customers who will take advantage of the cash discount is expected to increase from the current 50 percent to 70 percent with the new credit terms. Bad debt losses currently average 4 percent of sales and are not expected to change significantly if Hill changes its credit policy. Annual credit sales are $3.5 million, the variable cost ratio is 60 percent and the required pretax rate of return (i.e., the opportunity cost) on receivables investment is 14 percent. The company does not expect its inventory level to change as a result of its proposed change in credit terms. Assuming that Hill does decide to increase the size of its cash discount, determine the following:
- The earnings on the funds released by the change in credit terms
- The cost of the additional cash discounts taken
- The net effect on Hill’s pretax profits.
