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The following information regarding a change in credit policy was assembled by the Wilson Wax Company. The company has a required rate of return of 10 percent and a variable cost ratio of 60 percent.
The pretax cost of carrying the additional investment in receivables, using a 360-day year, would be:
Choice 'a' is correct.
Step 1 Determine the average accounts receivable balance and the additional accounts receivable as follows:
Therefore, the accounts receivable balance is $96,000 higher under the new credit policy.
Step 2 Determine the additional INVESTMENT in the additional accounts receivable.
Although Wilson has an additional $96,000 in accounts receievable, Wilson's actual investment in the additional accounts receivable is only 60% of $96,000 (because variable costs are 60% of sales). Wilson's investment in the additional accounts receivable is calculated as follows:
$96,000 x 60% = $57,600
Step 3 Calculate the cost of carrying the additional accounts receivable.
Wilson's additional investment in accounts receivable is $57,600 and we are given a 10% required rate of return. This means that Wilson's carrying cost of $5,760 is calculated as follows:
$57,600 x 10% = $5,760
Choices 'b', 'c', and 'd' are incorrect, per the above calculation.