Chapter 7, Problem 21P

Global Services is considering a promotional campaign that will increase annual credit sales by $\text{\$450,000}$ . The company will require investments in accounts receivable, inventory, and plant and equipment. The turnover for each is as follows:

All $\text{\$450,000}$ of the sales will be collectible. However, collection costs will be 6 percent of sales, and production and selling costs will be 71 percent of sales. The cost to carry inventory will be 4 percent of inventory. Depreciation expense on plant and equipment will be 5 percent of plant and equipment. The tax rate is 30 percent.

a. Compute the investments in accounts receivable, inventory, and plant and equipment based on the turnover ratios. Add the three together.

b. Compute the accounts receivable collection costs and production and selling costs and add the two figures together.

c. Compute the costs of carrying inventory.

d. Compute the depreciation expense on new plant and equipment.

e. Add together all the costs in parts b, c, and d.

f. Subtract the answer from part e from the sales figure of $\text{\$450,000}$ to arrive at income before taxes. Subtract taxes at a rate of 30 percent to arrive at income after taxes.

g. Divide the aftertax return figure in part f by the total investment figure in part a. If the firm has a required return on investment of 8 percent, should it undertake the promotional campaign described throughout this problem?

Summary Introduction

To calculate: Investments in accounts receivable, inventory, and plant & equipment based on the turnover ratios.

Introduction:

Accounts receivable:

It is the amount that the company has not received yet for the services already rendered by it or the goods already sold. Accounts receivable is mentioned under the head assets in the balance sheet.

Inventory:

It is the goods including raw materials which are kept in store either for the selling or for further usage in production purpose. The inventory includes raw materials, unfinished as well as finished goods.

Answer to Problem 21P

For Global Services, the investments in accounts receivable should be $225,000, in inventory should be $75,000, and plant & equipment is $450,000 . The total investment should be $750,000.

Explanation of Solution

The calculation of investment to be made in accounts receivables:

$\begin{array}{c}\text{Accounts receivable = }\frac{\text{Sales}}{\text{Accounts receivable turnover}}\\ =\frac{\$450,000}{2}\\ =\$225,000\end{array}$

The calculation of investment to be made in inventory:

$\begin{array}{c}\text{Inventory = }\frac{\text{Sales}}{\text{Inventory turnover}}\\ =\frac{\$450,000}{6}\\ =\$75,000\end{array}$

The calculation of investments to be made in plant and equipment:

$\begin{array}{c}\text{Plant and equipment = }\frac{\text{Sales}}{\text{Plant and equipment turnover}}\\ =\frac{\$450,000}{1}\\ =\$450,000\end{array}$

The calculation of total investment:

$\begin{array}{c}\text{Total investment = Accounts receivable + Inventory + Plant and equipment}\\ \text{=\$225,000 + \$75,000 + \$450,000}\\ \text{=\$750,000}\end{array}$

Summary Introduction

To calculate: The cost of Accounts receivable collection, production, and selling. Also, find the total cost.

Introduction:

Accounts receivable:

Accounts receivable is the amount that the company has not received yet for already rendered services or goods sold. Accounts receivable is mentioned under the head assets in the balance sheet.

Production and selling cost:

The cost which is incurred for the production and distribution is referred to as production and selling cost. This cost is considered as variable, as it keeps on varying with the level of production.

Answer to Problem 21P

The collection cost of Global Services is $27,000 and its production and selling costs is $319,500.

Explanation of Solution

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The calculation of collection cost:

$\begin{array}{c}\text{Collection cost = 6\% of plant and equipment}\\ \text{= 6\% × \$450,000}\\ \text{= \$27,000}\end{array}$

The calculation of production and selling costs:

$\begin{array}{l}\text{Production and selling costs = 71 percent of plant and equipment }\\ \text{ = 71 \% }\times \text{ \$450,000 }\\ \text{ = \$319,500}\end{array}$

The calculation of total cost related to accounts receivables:

$\begin{array}{l}\text{Total costs related to accounts receivable = Collection cost + production and selling cost }\\ \text{ = \$27,000 + \$319,500}\text{. }\\ \text{ = \$346,500}\end{array}$

Summary Introduction

To calculate: The cost of carrying inventory.

Introduction:

Inventory carrying cost:

All the expenses related to the holding or storing the inventory is referred to as inventory carrying cost. This varying cost determines the level of inventory to be held by a company.

Answer to Problem 21P

The inventory carrying cost of Global Services is $3,000.

Explanation of Solution

The calculation of the inventory carrying cost of Global Services:

$\begin{array}{l}\text{Inventory carrying cost = 4\% of inventory}\text{. }\\ \text{ = 4 \% }\times \text{ \$75,000}\text{. }\\ \text{ = \$3,000}\text{.}\end{array}$

Summary Introduction

To calculate: Depreciation expense charged on new plant and equipment.

Introduction:

Depreciation:

The non-cash expense referred to as depreciation, which is gradual decrease in the value of fixed assets due to the wear and tear or continuous usage. Depreciation is calculated either through straight line or diminishing balance method.

Answer to Problem 21P

The depreciation expense of Global services is $22,500.

Explanation of Solution

The calculation of depreciation expense:

$\begin{array}{c}\text{Depreciation Expense}=\text{Rate}\times \text{Plant and equipment}\text{. }\\ =\text{5\%}\times \text{\$450,000 }\\ =\text{\$22,500}\end{array}$

Summary Introduction

To calculate: The sum of all the costs in parts b, c, and d.

Introduction:

Production and selling cost:

The cost which is incurred for the production and distribution is referred to as production and selling cost.

Inventory carrying cost:

All the expenses related to the holding or storing the inventory is referred to as inventory carrying cost. This varying cost determines the level of inventory to be held by a company.

Depreciation:

The non-cash expense referred to as depreciation, which is gradual decrease in the value of fixed assets due to the wear and tear or continuous usage. Depreciation is calculated either through straight line or diminishing balance method.

Answer to Problem 21P

Total costs of Global Services are $372,000.

Explanation of Solution

The calculation of the sum of costs in part b, c, and d:

$\begin{array}{c}\text{Total cost = Total cost related to accounts receivable + Cost of carrying inventory + }\\ \text{Depreciation expense}\\ \text{= \$346,000 + \$3,000 + \$22,500}\\ \text{= \$372,000}\end{array}$

Summary Introduction

To calculate: The income before taxes.

Introduction:

Income before taxes:

The income before taxes is the measure of the company’s fiscal performance, which is computed by subtracting expenses from the revenue of the company.

Answer to Problem 21P

The income before taxes of Global Services is $78,000 and its income after taxes is $54,600.

Explanation of Solution

The calculation of income before tax:

$\begin{array}{c}\text{Income before tax = Sales - Total cost}\\ \text{= \$450,000 - 372,000}\\ \text{= \$78,000}\end{array}$

The calculation of income after tax:

$\begin{array}{c}\text{Income after tax = Income before tax - tax}\\ \text{= \$78,000 - \$23,400}\\ \text{= \$54,600}\text{.}\end{array}$

Summary Introduction

To calculate: The result after division of the after-tax return figure by total investment and further determine whether it should undertake the promotional campaign.

Introduction:

After-tax return:

After-tax return is the measure of a company’s performance. It is calculated by subtracting the tax from the revenue of the company. This after tax return is considered for distribution amongst the shareholders.

Answer to Problem 21P

The figure obtained after dividing income after taxes by the total investment is 7.28%.

No, the company should not undertake the promotional campaign.

Explanation of Solution

The calculation of percentage of income after taxes to total investment:

$\begin{array}{c}\text{\% of income after taxes to total investments}=\frac{\text{Income after taxes}}{\text{Total investment}}\times 100\\ =\frac{\text{\$54,600}}{\text{\$750,000}}\times 100\\ =\text{7}\text{.28\%}\end{array}$

As the figure obtained is not more than 8 %, the company should not undertake the campaign.