Question

Brown Corporation is investigating the optimal level of current assets for the coming year. The following parameters are applicable to the decision:

-Management expects sales to increase to approximately $20 million due to an asset expansion presently being undertaken.   

-Fixed assets total $10 million.

-The firm plans to maintain a 60 percent debt ratio. Half of the debt is short-term debt and half is long-term debt.

-Brown’s interest rate is currently 6 percent on the short-term and 8 percent on the long-term debt.

-Two alternatives regarding the projected current asset level are under consideration: (1) a tight policy where current assets would be 30 percent of projected sales and (2) a relaxed policy where current assets would be 50 percent of sales.

-Earnings before interest and taxes are projected to be 20 percent of total sales and the tax rate is 40 percent.

                        Required:

a) What is the expected return on equity under each asset level?

b) Why is the return on equity a preferred metric for making the decision?

c) Is it a valid assumption that sales are independent of the current asset policy?

d) How would the firm’s risk be affected by the different policies?

Answer 1

Assets:	Amount ($) - Tight	Amount ($) - Relaxed
Current assets	6 million	10 million
Fixed assets	10 million	10 million
Total assets	16 million	20 million
Liabilities:
Debt (60%)	9.6 million	12 million
Equity	7.4 million	8 million
Total liability	16 million	20 million

Particulars	Amount ($) - Tight	Amount ($) - Relaxed
EBIT	4 million	4 million
- interest
short term	0.06 x 4.8 = 0.288	0.06 x 6 = 0.36
long term	0.08 x 4.8 = 0.384	0.08 x 6 = 0.48
Total	0.672	0.84
EBT	3.328	3.16
-tax@40%	1.3312	1.264
EAT	1.9968 million	1.896 million

a) ROE (tight) = 1.9968/7.4 = 26.98%

ROE (relaxed) = 1.896/8 = 23.7%

b) ROE measures how much profit is being generated with the amount of money invested by shareholders. Therefore, it is being measured under each alternative to determine which one yields greater return on invested capital

c) No. Sales are not independent of current asset policy. The level of current assets such as available cash, current stock level, available marketable securities determine the level of sales that can be undertaken.

d) The tighter the policy the higher the expected returns. Current asset level could be decreased by a lower amount of account receivable. This can be made possible by providing higher discounts and a short collection period. This may result in additional costs but would most likely reduce bad debt expenses.