Question

CURRENT ASSETS INVESTMENT POLICY

Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $3 million, and the firm plans to maintain a 50% debt-to-assets ratio. Rentz's interest rate is currently 9% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 13% of total sales, and the federal-plus-state tax rate is 40%.

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

   Restricted policy		%
   Moderate policy		%
   Relaxed policy		%

b. In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption?

1. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.
2. 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.
3. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.
4. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.
5. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.

-Select-IIIIIIIVV

Answer 1

a. Calculation of ROE

Formula for ROE = Net income / Stockholder's equity

given,

Estimated Sales = $2 million

Total fixed assets = $3 million

Debt to asset ratio will remain at 50%

Calculation of net income under all the situation

Situation 1 (Restricted Policy)

Sales - $2 million

Total assets = Fixed assets + current assets

= $ 3 million + 45% of sales

= $ 3 million + $9,00,000

= $ 3.9 million

Debt ratio = Total Debt / Total Assets

If debt ratio is 50%, then

50% = $3.9 million / Total debt

      Total debt = $1.95 million

Interest @ 9% on $1.95 million = $1,75,500

EBIT = 13% of sales = $2,60,000

Total Equity = Total Assets - Total Debt

                     = $3.9 million - $1.95 million

                    = $1.95 millio

Income Statement :

Sales -                                   $ 2milliom

EBIT -                  $2,60,000

Less: Interest -                   $1,75,500

=                                          $84,500

Less: Tax @ 40% -           $33,800

Net Income =                    $50,700

Formula for ROE = Net income / Stockholder's equity

ROE = $50,700 / $1.95 million

          = 2.60 %

Situation 2 (Moderate Policy)

Sales - $2 million

Total assets = Fixed assets + current assets

= $ 3 million + 50% of sales

= $ 3 million + $1 million

= $ 4 million

Debt ratio = Total Debt / Total Assets

If debt ratio is 50%, then

50% = $4 million / Total debt

      Total debt = $2 million

Interest @ 9% on $2 million = $1,80,000

EBIT = 13% of sales = $2,60,000

Total Equity = Total Assets - Total Debt

                     = $4 million - $2 million

                    = $2 million

Income Statement :

Sales -                                   $ 2milliom

EBIT -                  $2,60,000

Less: Interest -                   $1,80,000

=                                          $80,000

Less: Tax @ 40% -           $32,000

Net Income =                    $48,000

Formula for ROE = Net income / Stockholder's equity

ROE = $48,000 / $2 million

          = 2.40 %

Situation 3 (Relaxed Policy)

Sales - $2 million

Total assets = Fixed assets + current assets

= $ 3 million + 60% of sales

= $ 3 million + $1.2 million

= $ 4.2 million

Debt ratio = Total Debt / Total Assets

If debt ratio is 50%, then

50% = $4.2 million / Total debt

      Total debt = $2.1 million

Interest @ 9% on $2.1 million = $1,89,000

EBIT = 13% of sales = $2,60,000

Total Equity = Total Assets - Total Debt

                     = $4.2 million - $2.1 million

                    = $2.1 million

Income Statement :

Sales -                                   $ 2milliom

EBIT -                  $2,60,000

Less: Interest -                   $1,89,000

=                                          $71,000

Less: Tax @ 40% -           $28,400

Net Income =                    $42,600

Formula for ROE = Net income / Stockholder's equity

ROE = $42,600 / $2.1 million

          = 2.02 %

b. The correct answer is ' No, this assumption would probably not be valid in a real world situation. A firm's current asset policy may have significant effect on sales'. In practical world, the sales do get affected by the current assets of a company, because it includes accounts receivable and inventories which are proportionately changes based on the sales policy of the company and company's sales also gets affected by elements of current assets.