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1.ABC Inc. currently grants no credit, but it is considering offering new credit terms: net 30. As a result, the price of its product will increase by $1.50 per unit. The original price per unit is $50. Expected sales will increase by 1,000 units per year. The original sales are 10,000 units. Variable costs will remain at $26 per unit and bad debt losses will amount to $3,000 per year. The firm will finance the additional investment in receivables by using a line of credit, which charges 5 percent interest. The firm’s tax rate is 40 percent. Should the firm begin extending credit under the terms described? (Assume ABC benefits from the credit policy change indefinitely.)
2.In Problem 1, ABC is switching to 2/10 net 30. It is estimated that 80 percent of customers will take advantage of the discount, while the remaining 20 percent will pay on day 30. The price will remain the same at $51.50 per unit, unit sales will remain at 11,000 per year, and variable costs will remain at $26 per unit. Bad debt losses will not be affected. Use a 40 percent tax rate and a 5 percent discount rate. Should the firm switch to the new policy?
What are the effects of leverage on shareholder wealth and the cost of capital?
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