Working Capital Policy Payne Products had $1.6 million in sales revenues in the

Question

Working Capital Policy

Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $3 million of fixed assets and intends to keep its debt ratio at its historical level of 50%. Payne's debt interest rate is currently 10%. You are to evaluate three different current asset policies: (1) a tight policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes is expected to be 13% of sales. Payne's tax rate is 40%.

1.What is the expected return on equity under each current asset level? Round your answers to two decimal places.

In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption?
-Select-
I. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.
II. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.
III. No, this assumption would probably not be valid in a real world situation. A firm's current asset policies may have a significant effect on sales.
IV. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.
V. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.

Why or why not?

How would the overall riskiness of the firm vary under each policy?

Explanation / Answer

Sales = 1.6*(1+25%) = 2 million

Fixed assets = 3 million

Debt ratio = 50%, Equity = 1 - 50% = 50%

Tight policy

Current assets = 45% * 2 = 0.9

Total assets = 3 + 0.9 = 3.9

Equity = 50%*3.9 = 1.95,

Debt = 1.95, Interest = 10%*1.95 = 0.195

EBIT = 13%*2 = 0.26

EBT = 0.26 - 0.195 = 0.065

PAT = 0.065*(1-40%) = 0.039

ROE = 0.039 / 1.95 = 2%

Moderate policy

Current assets = 50% * 2 = 1

Total assets = 3 + 1 = 4

Equity = 50%*4 = 2,

Debt = 2, Interest = 10%*2 = 0.2

EBIT = 13%*2 = 0.26

EBT = 0.26 - 0.2 = 0.06

PAT = 0.06*(1-40%) = 0.036

ROE = 0.036 / 2 = 1.8%

Relaxed policy

Current assets = 60% * 2 = 1.2

Total assets = 3 + 1.2 = 4.2

Equity = 50%*4.2 = 2.1,

Debt = 2.1, Interest = 10%*2.1 = 0.21

EBIT = 13%*2 = 0.26

EBT = 0.26 - 0.21 = 0.05

PAT = 0.05*(1-40%) = 0.03

ROE = 0.03 / 2.1 = 1.43%

Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.

(Option E)

Higher the current assets will increase debt levels and riskiness increases and ROE decreases

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