Question
Alpha Ltd. is examining the question of relaxing its credit policy. It sells at present 20,000 units at a price of Rs. 100 per unit. The variable cost per unit is Rs. 88 and average cost per unit at the current sales volume is Rs. 92. All the sales are on credit, the average collection period being 36 days.
A relaxed credit policy is expected to increase sales by 10% and the average age of receivables to 60 days. Assuming 15% return, should the firm relax its credit policy?
Answer :
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To analyze whether Alpha Ltd. should relax its credit policy, we need to examine the financial implications of the proposed change on sales, costs, and the investment in accounts receivable, using the working capital management perspective. We will calculate the current profit, incremental profit from additional sales, and the cost of additional receivables, and then determine whether the net effect is positive. Current Situation: Alpha Ltd. currently sells 20,000 units at Rs. 100 each, generating total sales revenue of: [ 20,000 \times 100 = 2,000,000 \text{ Rs.} ] The variable cost per unit is Rs. 88, so total variable cost is: [ 20,000 \times 88 = 1,760,000 \text{ Rs.} ] The contribution margin per unit is: [ \text{Price} - \text{Variable cost} = 100 - 88 = 12 \text{ Rs. per unit.} ] The total contribution margin for 20,000 units is: [ 12 \times 20,000 = 240,000 \text{ Rs.} ] The average cost per unit is Rs. 92, which includes fixed costs. Total cost at current sales volume is: [ 20,000 \times 92 = 1,840,000 \text{ Rs.} ] Profit at current sales volume is: [ \text{Revenue} - \text{Total cost} = 2,000,000 - 1,840,000 = 160,000 \text{ Rs.} ] The average collection period is 36 days, meaning that the company has receivables outstanding for roughly a month. The average accounts receivable can be calculated as: [ \text{Receivables} = \frac{\text{Annual Credit Sales}}{360} \times \text{Collection Period} =
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