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 55% debt-to-assets ratio. Rentz's interest rate is currently 8% 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 14% 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		%

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

Answer 1

(1)  

The shareholders' equity = company’s assets - debt

Sales	2000000
Debt to asset	55%
Equity to asset	45%	1-55%
EBIT(14% of sales)	280000	14%*2000000
Policy	Restricted	Moderate	Relaxed
Current asset	45% of Sale	50% of Sale	60% of Sale
Current asset	900000	1000000	1200000
Fixed asset	3000000	3000000	3000000
Total asset	3900000	4000000	4200000
Debt (Asset*55%)	2145000	2200000	2310000
Equity (Asset*45%)	1755000	1800000	1890000
Total Liability	3900000	4000000	4200000
EBIT	280000	280000	280000
Interest (8% of debt)	-171600	-176000	-184800
EBT	108400	104000	95200
Tax(40%)	-43360	-41600	-38080
EAT	65040	62400	57120
	Restricted	Moderate	Relaxed
ROE (EAT/Equity)	3.706%	3.467%	3.022%
	65040/1755000*100	62400/1800000*100	57120/1890000*100

(2) We assume that expected sales are independent of the current assets investment policy. Is this a valid assumption

ANS - (V) 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

Summary :- The expected return on equity under each current assets level is Restricted policy is 3.71%, Moderate policy is 3.47% and Relaxed policy is 3.02% and each policy has its advantages & disadvantages like

1. Restricted policy will reduce sales but will also reduce bad debt and other collection expenses and so risk

2. Relaxed policy will increase sales but will also increase bad debt and collection costs and so risk increases

3. Moderate policy is largely followed by major companies as they follow how market behaves so risk is moderate here but it still depends on how company is able to tackle the situatioN