Question

Payne Products had $3.2 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $3 million of fixed assets and intends to keep its debt ratio at its historical level of 40%. Payne's debt interest rate is currently 10%. You are to evaluate three different current asset policies: (1) a tight policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes is expected to be 13% of sales. Payne's tax rate is 40%.

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

Tight policy %

Moderate policy %

Relaxed policy %

B) In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption?

I. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.

II. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.

III. 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.

IV. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.

V. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.

Answer 1

Ans.

A.

The amount of expected sales = $ 3,200,000 * 1.25 = $ 4,000,000

	Current Assets	Fixed Assets	Total Assets	Debt (40%)	Equity (60%)
Tight Policy	$                      1,800,000.00	$                3,000,000.00	$ 4,800,000.00	$                    1,920,000.00	$              2,880,000.00
	[45% of $ 4,000,000]			[40% of 4,800,000]	[60% of 4,800,000]
Moderate Policy	$                      2,000,000.00	$                3,000,000.00	$ 5,000,000.00	$                    2,000,000.00	$              3,000,000.00
	[50% of $ 4,000,000]			[40% of 5,000,000]	[60% of 5,000,000]
Relaxed Policy	$                      2,400,000.00	$                3,000,000.00	$ 5,400,000.00	$                    2,160,000.00	$              3,240,000.00
	[60% of $ 4,000,000]			[40% of 5,400,000]	[60% of 5,400,000]

	Tight Policy	Moderate Policy	Relaxed Policy
EBIT ( 13% of sales)	$                          520,000.00	$                   520,000.00	$      520,000.00
Interest @ 10%	$                        (192,000.00)	$                 (200,000.00)	$   (216,000.00)
EBT	$                          328,000.00	$                   320,000.00	$      304,000.00
Tax @ 40%	$                        (131,200.00)	$                 (128,000.00)	$   (121,600.00)
Net Income (a)	$                          196,800.00	$                   192,000.00	$      182,400.00
Equity (b)	$                      2,880,000.00	$                3,000,000.00	$ 3,240,000.00
Return on Equity (a/b)	6.83%	6.40%	5.63%

B.

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.

So option III is correct.