Question

Richmond Enterprises is considering whether to pursue a restricted or relaxed current asset investment policy. The firm’s annual sales are $400,000; its fixed assets are $100,000; debt and equity are each 50 percent of total assets. EBIT is $36,000, the interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. With a restricted policy, current assets will be 15 percent of sales. Under a relaxed policy, current assets will be 25 percent of sales. What is the difference in the projected ROEs between the restricted and relaxed policies?

Answer 1

EBIT = $36,000

Sales = $ 400,000

Restricted Policy:

Current asset = 15% of Sales = 0.15*400,000

Current asset = $60,000

Total asset = Current asset + Fixed asset

Total asset = 60,000 + 100,000

Total asset = $160,000

Debt = Equity = 50% of Total asset

Debt = Equity = 0.5*160,000

Debt = Equity = $80,000

Interest on Debt = 10% of Debt

Interest on Debt = 0.1*80,000

Interest on Debt = $8,000

EBT = EBIT - Interest = 36000 - 8000

EBT(Earning before tax) = $28,000

Tax = 40% of EBT = 0.4*28,000

Tax = $11,200

Net Income = EBT - Tax = 28,000 - 11,200

Net Income = $16,800

ROE(Return on Equity) = Net Income/Equity

ROE = 16800/80000

ROE of Restricted Policy= 21%

Relaxed Policy:

Current asset = 25% of Sales = 0.25*400,000

Current asset = $100,000

Total asset = Current asset + Fixed asset

Total asset = 100,000 + 100,000

Total asset = $200,000

Debt = Equity = 50% of Total asset

Debt = Equity = 0.5*200,000

Debt = Equity = $100,000

Interest on Debt = 10% of Debt

Interest on Debt = 0.1*100,000

Interest on Debt = $10,000

EBT = EBIT - Interest = 36000 - 10000

EBT(Earning before tax) = $26,000

Tax = 40% of EBT = 0.4*26,000

Tax = $10,400

Net Income = EBT - Tax = 26,000 - 10,400

Net Income = $15,600

ROE(Return on Equity) = Net Income/Equity

ROE = 15600/100000

ROE of Relaxed Policy= 15.6%

Difference Between ROE = Restricted Policy ROE - Relaxed Pociy ROE = 21% - 15.6%

Difference Between ROE = 5.4%