Scott Equipment Organization is investigating the use of variouscombinations of

Question

Scott Equipment Organization is investigating the use of variouscombinations of short-term and long-term debt in financing itsassets. Assume that the organization has decided to employ $30million in current assets, along with $35 million in fixed assets,in its operations next year. Given the level of current assets,anticipated sales and Earnings Before Interest and Taxes (EBIT) fornext year are $60 million and $6 million, respectively. Theorganization’s income tax rate is 40%; Stockholders’equity will be used to finance $40 million of its assets, with theremainder being financed by short-term and long-term debt.Scott’s is considering implementing one of thefollowing financing policies:

Amount of Short-Term Debt

Financial Policy

In mil.

LTD (%)

STD (%)

Aggressive
(large amount of short-term debt)

$24

8.5

5.5

Moderate
(moderate amount of short-term debt)

$18

8.0

5.0

Conservative
(small amount of short-term debt)

$12

7.5

4.5

Determine the following for each of the financingpolicies:

1)   Expected rate of return on stockholders’equity

Financial Policy

In mil.

LTD (%)

STD (%)

Aggressive
(large amount of short-term debt)

$24

8.5

5.5

Moderate
(moderate amount of short-term debt)

$18

8.0

5.0

Conservative
(small amount of short-term debt)

$12

7.5

4.5

Explanation / Answer

Financial Policy

ROE

Aggressive Policy

3.96%

Moderate Policy

5.49%

Conservative Policy

6.84%

Calculating Expected Rate ofReturn on Stockholder's Equity (or) ROE (Return onEqutiy): Rate of Return on Stock holder's Equity(or) ROE = Net Income / Stockholder's Equity Calcualting Net Income underAggressive Policy: Earnings Before Interest & Taxes (EBIT) $6,000,000 Less: Interest on Debt [$24,000,000 *(8.5%+5.5%)] ($3,360,000) Earnings Before Taxes (EBT) $2,640,000 Less: Tax (40%) ($1,056,000) Net Income $1,584,000 ROE = Net Income / Stock Holder'sEquity ROE = $1,584,000 /$40,000,000   = 0.0396 (or) 3.96% Calculating Net Income underModerate Polciy: Earnings Before Interest & Taxes (EBIT) $6,000,000 Less: Interest on Debt [$18,000,000 * (8%+5%)] ($2,340,000) Earnings Before Taxes (EBT) $3,660,000 Less: Tax (40%) ($1,464,000) Net Income $2,196,000 ROE = $2,196,000 /$40,000,000 = 0.0549 (or) 5.49% Calculating Net Income underConservative Policy: Earnings Before Interest & Taxes (EBIT) $6,000,000 Less: Interest on Debt [$12,000,000 *(7.5%+4.5%)] ($1,440,000) Earnings Before Taxes (EBT) $4,560,000 Less: Tax (40%) ($1,824,000) Net Income $2,736,000 ROE = $2,736,000 /$40,000,000 = 0.0684 (or) 6.84%

Financial Policy

ROE

Aggressive Policy

3.96%

Moderate Policy

5.49%

Conservative Policy

6.84%

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