The Rentz Corporation is investing the optimal level of currentassets for the co

Question

The Rentz Corporation is investing the optimal level of currentassets for the coming year. Management expects sales to increase toapproximately $2 million as a result of an asset expansionpresently being undertaken. Fixed assets total $1 million, and thefirm plans to maintain a 60 percent debt ratio. Rentz’sinterest rate is currently 8 percent on both short-term andlong-term debt (which the firm uses in its permanent structure).Three alternatives regarding the projected current asset level areunder consideration:

(1) A tight policy where current assets would be only 45 percent ofprojected sales,

(2) A moderate policy where current assets would be 50 percent ofsale, and

(3) A relaxed policy where current assets would be 60 percent ofsales. Earnings before interest and taxes should be 12 percent oftotal sales, and the federal-plus-state tax rate is 40 percent.

a.     What is the expected return on equityunder each current asset level?

b.     In this problem, we assume that expectedsales are independent of the current asset policy. Is this a validassumption?

c.      How would the firm’s risk beaffected by the different policies?

Explanation / Answer

Tight Policy

Moderate Policy

Relaxed Policy

Current Assets of TightPolicy ($2,000,000 * 45%)   = $900,000 Current Assets of Moderate Policy($2,000,000 * 50%)   = $1,000,000 Current Assets of Relaxed Policy($2,000,000 * 60%)   = $1,200,000

Tight Policy

Moderate Policy

Relaxed Policy

Current Assets $900,000 $1,000,000 $1,200,000 Fixed Assets $1,000,000 $1,000,000 $1,000,000 Total Assets $1,900,000 $2,000,000 $2,200,000 Debt ratio (60% on Total Assets) $1,140,000 $1,200,000 $1,320,000 Equity $760,000 $800,000 $880,000 Total Debt + Equity $1,900,000 $2,000,000 $2,200,000 EBIT(12% on $2,000,000) $240,000 $240,000 $240,000 Interst on both short & Longterm debt (8%) $91,200 $96,000 $105,600 Earning Before Tax $148,800 $144,000 $134,400 Tax (40%) $59,520 $57,600 $53,760 Net Income $89,820 $86,400 $80,640 Return on Equity (ROE) 11.82% 10.80% 9.16% Return on Equity (ROE) = Net Income /Shareholder's Equity (b) No it is not a valid assumption.Why because firms current assets policy like Accounts receivables,collection periods, and discounts will have a significantimpact on sales.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.