Practice Problem 4 (20 minutes) Stadt Ltd. currently offers terms…

Practice Problem 4 (20 minutes)
Stadt Ltd. currently offers terms of 2/10 net 45 to its credit sales customers. While these
terms are more lenient than other companies’ terms in the same industry, Stadt
originally adopted them to gain a larger market share. Unfortunately, Stadt has more
recently seen its bad-debt costs increase, and sales volume has levelled off despite
growth in the industry and overall positive economic conditions. Stadt is considering
changing its trade-credit terms to 0.50/10 net 30 to be more in line with its competitors.
Stadt’s management team has provided you with the following information:
1. Sales are expected to decrease by 5% from the current level of $28.5 million
annually with the change in terms. Variable costs on sales are currently 45%
(which includes cost of goods sold) and are expected to remain so.
2. Bad debts are expected to decrease with the new terms. Currently, Stadt has
bad debts of 2.75% of sales. It is estimated that this will decrease to 1.5% of all
sales.
3. Cost of goods sold is 35% of sales, and Stadt has an inventory turnover of 6.5,
which is in line with the industry standard. Stadt expects to continue this
inventory turnover rate for the foreseeable future.
4. Currently, Stadt has an average collection period of 60 days, with 30% of
customers taking the discount. With the change in credit terms, it is estimated
that 25% of customers will take advantage of the discount period, 40% will pay
within 30 days, 25% will pay within 60 days, and the remaining 8.5% who do pay
will pay in 90 days. Bad debts are not counted as receivables in the calculation of
average collection period in this problem.
5. The rate of return Stadt expects from any investment in working capital is 6%.
Required:
Should Stadt consider changing its credit terms? Explain your results.