Financial management revision question and answer

Dawamu Ltd., which operates in the retail sector selling a single product, is considering a change of credit policy which will result in an increase in the average collection period of debts from one to two months. The relaxation of the credit policy is expected to produce an increase in sales in each year, amounting to 25% of the current sales volume. The following information is available.

1. Selling price per unit of product – Sh.1,000
2. Variable cost per unit of product – Sh.850
3. Current annual sales of product – Sh.240,000,000
4. Dawamu Ltd.‟s required rate of return on investments is 20%.
5. It is expected that increase in sales would result in additional stock of Sh.10,000,000 and additional creditors ofSh.2,000,000.

Advise Dawamu Ltd. on whether or not to extend the credit period offered to customers, if:

(i) All customers take the longer credit period of two months.
(ii) Existing customers do not change their payment habits and only the new
customers will take a full two months‟ credit.

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