Michigan Pharmaceuticals, Inc., a wholesale distributor of ethical drugs to local pharmacies, has been experiencing a relatively long average collection period because many of its customers face liquidity problems and delay their payments well beyond the due date. In addition, its bad-debt loss ratio is high because a number of pharmacies have closed due to financial difficulties. To avoid these problems in the future, Michigan Pharmaceuticals is considering a plan to institute more stringent credit standards to keep the average collection period and bad-debt losses from rising beyond acceptable limits. Specifically, the firm plans to refuse to grant additional credit to any current customers more than 15 days past due on their payments. Such a change in credit policy is expected to reduce current annual sales of $6.5 million by 20 percent, reduce the average collection period from 110 days to 75 days, and lower bad-debt losses from 8 to 4 percent. Due to the expected decrease in sales, the company estimates that its inventories will decrease by $250,000. The firm’s variable cost ratio is 0.75, and its required pretax return on investments in receivables and inventories is 15 percent. Determine the net effect of this plan on the pretax profits of Michigan Pharmaceuticals.
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