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Big Retailer (BR) follows a moderate current asset investment policy, but is now considering a change,...

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 $500,000; 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.

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Expert Solution

Calculating ROE under restricted policy

Sales = $1400000, Fixed assets = $950000

Under restrictive policy, Current assets = 20% of sales = 20% x 1400000 = 280000

Total assets = Fixed Assets + Current Assets = 950000 + 280000 = 1230000

We know that Total assets = Total capital = 1230000

Debt = 40% of total capital = 40% x 1230000 = 492000

Equity = 60% of total capital = 60% x 1230000 = 738000

Interest on debt = Interest rate x debt = 8% x 492000 = 39360

Net income = (EBIT - Interest)(1-Tax rate) = (500000 - 39360)(1-20%) = 460640 x 80% = 365812

Return on Equity = Net income / Equity = 365812 / 738000 = 49.5680%

Calculating ROE under relaxed policy

Sales = $1400000, Fixed assets = $950000

Under relaxed policy, Current assets = 35% of sales = 35% x 1400000 = 490000

Total assets = Fixed Assets + Current Assets = 950000 + 490000 = 1440000

We know that Total assets = Total capital = 1440000

Debt = 40% of total capital = 40% x 1440000 = 576000

Equity = 60% of total capital = 60% x 1440000 = 864000

Interest on debt = Interest rate x debt = 8% x 576000 = 46080

Net income = (EBIT - Interest)(1-Tax rate) = (500000 - 46080)(1-20%) = 453920 x 80% = 363136

Return on Equity = Net income / Equity = 363136 / 864000 = 42.0296%

Difference between ROE of Restrictive and Relaxed policy = 49.5680% - 42.0296% = 7.5384% = 7.54% (rounded to two decimal places)

Answer: 7.54%

jeff jeffy answered 8 months ago
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