Ganga Ltd has credit sales of ₹ 60 lakh, an average collection period of 30 days and bad debts of 1% of sales. A relaxed credit policy would raise credit sales to ₹ 70 lakh, the collection period to 60 days and bad debts to 2% of sales. Variable costs are 75% of sales and fixed costs of ₹ 6 lakh a year will not change. The required return on investment in receivables is 12% per annum, and the investment in receivables is to be measured at total cost (variable cost plus fixed cost). Taking 360 days in a year, the net effect on annual profit of adopting the new policy is:

Correct answer: B) Increase of ₹ 1,04,000

Explanation

Total cost: present = 45 lakh + 6 lakh = ₹ 51 lakh; proposed = 52.5 lakh + 6 lakh = ₹ 58.5 lakh. Investment in receivables at total cost: present = 51,00,000 x 30/360 = ₹ 4,25,000; proposed = 58,50,000 x 60/360 = ₹ 9,75,000. Cost of funds at 12%: present ₹ 51,000, proposed ₹ 1,17,000, an increase of ₹ 66,000. Extra contribution = 10,00,000 x 25% = ₹ 2,50,000, and bad debts rise from ₹ 60,000 to ₹ 1,40,000 (+ ₹ 80,000). Net gain = 2,50,000 - 66,000 - 80,000 = ₹ 1,04,000. Valuing receivables at variable cost only gives ₹ 1,10,000, at sales value gives ₹ 90,000, and ignoring the cost of funds gives ₹ 1,70,000.