Question

10 Big Retailer (BR) follows a moderate current asset investment policy, but is now considering a change, perhaps to a restricted or maybe to a relaxed policy. BR’s annual sales are $1,400,000; its fixed assets are $950,000; its target capital structure calls for 40% debt and 60% equity; its EBIT is $550,000; the interest rate on debt is 8%; and its tax rate is 20%. With a restricted policy, current assets will be 20% of sales, while under a relaxed policy, current assets will be 35% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? Enter your answer rounded to two decimal places. Do not enter % in the answer box. For example, if your answer is 0.12345 or 12.345% then enter as 12.35 in the answer box.

Answer 1

Restricted policy
Sales =	1400000
Current assets = 20 % of sales=	280000
Fixed Assets =	950000
Total Assets = Fixed assets + Current assets =	1230000
Capital structure = 40% debt, 60% equity
So, Equity = 60% of total assets=	738000
Debt = 40% of Total assets	492000
EBIT =	550000
Interest = 8% of debt
8% of debt 492000	39360
Tax rate =	20%
Net income = ( EBIT-Interest) * (1-tax rate)
(550000-39360)*(1-20%)=	408512
ROE formula = Net income / Equity
408512/738000	0.5535392954	or 55.35%
So, ROE under restricted policy is 55.35%
Relaxed policy
Sales =	1400000
Current assets = 35 % of sales=	490000
Fixed Assets =	950000
Total Assets = Fixed assets + Current assets =	1440000
Capital structure = 40% debt, 60% equity
So, Equity = 60% of total assets=	864000
Debt = 40% of Total assets	576000
EBIT =	550000
Interest = 8% of debt
8% of debt 576000	46080
Tax rate =	20%
Net income = ( EBIT-Interest) * (1-tax rate)
(550000-46080)*(1-20%)	403136
ROE formula = Net income / Equity
403136/864000	0.4665925926	or 46.66%
So, ROE under relaxed policy is 46.66%
Under Restricted policy ROE is 55.35% while under Relaxed policy is 46.66%. so there is
difference of 8.69% in RoE. Roe is more in case of Restricted policy. So this is favourable.

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