Hardwig Inc. is considering whether to pursue a restricted or relaxed current as
ID: 2748602 • Letter: H
Question
Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.
What are the expected ROEs under the restricted and relaxed policies, respectively?
Explanation / Answer
Fixed Assets Turnover ratio = Total revenue or sales/Total assets
4 = $ 3600000/Total Aseets
Total Assets= $ 3600000/4
Total Assets = $ 900000
UNDER RESTRICTED POLICY
Assets Turnover Ratio =2.5
Total Assets= $ 3600000/2.5
= $ 14,40,000
Debt and common equity are each 50% of total assets.
So Debt = $ 1440000/2 = $ 720000
Equity = $ 1440000/2 = $ 720000
Interest will be 10 percent of $ 720000 = $ 72000
COMPUTATION OF RETURN ON EQUITY
a) EBIT = $ 150000
b)Less: Interest = $ (72000)
c) EBT( a-b ) = $ 78000
d)less: Tax @40%of ( c ) = $ 31200
e) EAT ( c-d ) = $ 46800
f) ROE = EAT / Shareholders Funds = 46800/720000 = 6.5%
UNDER RELAXED POLICY
Assets Turnover Ratio =2.2
Total Assets= $ 3600000/2.2
= $ 16,36,363.63
Debt and common equity are each 50% of total assets.
So Debt = $ 16,36,363.63/2 = $ 8,18,181.81
Equity = $ 16,36,363.63/2 = $ 8,18,181.81
Interest will be 10 percent of 8,18,181.81 = $ 81,818.18
COMPUTATION OF RETURN ON EQUITY
a) EBIT = $ 150000
b)Less: Interest = $ (81,818.18)
c) EBT( a-b ) = $ 68181.82
d)less: Tax @40%of ( c ) = $ 27272.73
e) EAT ( c-d ) = $ 40909.09
f) ROE = EAT / Shareholders Funds = 40909.09/8,18,181.81 = 5%
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