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Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The...

Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2. Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its debt ratio, interest rate, and tax rate will all remain the same. In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies?

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Expert Solution

Fised Assets turnover ratio = Sales/Fixe Assets
Fixed Assets = Sales / Fixed Assets turnve ratio = 3,600,000/4 = 900,000
Under Restrictive policy asset turnover = 2.5 = Sales* (1-15%)/Total Assets
Total Assets = 3,600,000 * (1-15%)/2.5 = 1,224,000
Debt = Equity = Total assets/2 =1,224,000/2 = 612000
Net income in restrictive policy = (EBIT * ( 1- 10%) - Interest) * (1 - tax rate) = (150,000 * 0.9 - 612000*10%)* ( 1-40%)= 44280
Restrictive policy ROE = Net income/Equity = 44280/612000 = 7.235%

Under Relaxed policy
asset turnover = 2.2 = Sales/Total Assets
Total Assets = 3,600,000 /2.2 = 1,636,363.636
Debt = Equity = Total assets/2 =1,636,363.636/2 = 818,181.8181
Net income in restrictive policy = (EBIT - Interest) * (1 - tax rate) = (150,000 - 818,181.8181*10%)* ( 1-40%)= 40909.0909
Restrictive policy ROE = Net income/Equity = 40909.0909/818,181.8181 = 5%

Difference in ROE = 7.235% - 5% = 2.235%

Best of Luck. God Bless

jeff jeffy answered 2 years ago
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