Question

Problem 16-13
Current Asset Usage Policy

Payne Products had $1.6 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 $1 million of fixed assets and intends to keep its debt ratio at its historical level of 55%. Payne's debt interest rate is currently 10%. You are to evaluate three different current asset policies: (1) a restricted 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 are expected to be 11% of sales. Payne's tax rate is 35%.

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	%

In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption?
I. Sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.
II. The current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.
III. The current asset policies followed by the firm mainly influence the level of fixed assets.
IV. 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.
V. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.
-Select-IIIIIIIVVItem 4

Why or why not?

The input in the box below will not be graded, but may be reviewed and considered by your instructor.

How would the overall risk of the firm vary under each policy?

The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Answer 1

most recent year sales = 1600000 $

expected sales for this year = 1600000 $ * 125%

= 2000000 $ or 2 million $

existing debt equity ratio = 55 ;45 i.e. = 11:9

currentv interest rate on debt = 10%

fixed asset base = 1000000 $

under different policies

cureent assets - restricted policy = 45 % of sales

= 45 % * 2000000 $

= 900000 $

medium policy = 50% of sales

= 50% * 2000000

= 1000000 $

relaxed policy = 60 % of sales

= 60 % of 2000000

= 1200000 $

total asset = fixed asset + current asset

restricted policy = 1000000 + 900000

= 1900000 $

medium policy = 1000000 + 1000000

= 2000000 $

relaaxed policy = 1000000 + 1200000

= 2200000 $

debt base under the

restricted policy = 55% of 1900000 $

= 1045000 $

medium policy = 55% of 2000000 $

= 1100000 $

relaxed policy = 55 % of 2200000 $

= 1210000 $

equity under the

restricted policy = 1900000 - 1045000

= 855000 $

medium policy = 2000000 - 1100000

= 900000 $

relaxed policy = 2200000 - 1210000

= 990000 $

interest paid under the

restricted policy = 10 % * 1045000

= 104500 $

medium policy = 10 % of 1100000

= 110000 $

relaxed policy = 10% * 1210000

= 121000 $

EBIT = 11% * 2000000

= 220000 $

EBT = EBIT - interest

EBT under the

retsricted policy = 220000 $ - 104500 $

= 115500 $

medium policy = 220000 $ - 110000 $

= 110000 $

relaxed policy = 220000 $ - 121000 $

= 99000 $

Tax under the

Restricted policy = EBT *35%

= 115500 $ * .35

= 40425 $

medium policy = 110000 * .35

= 38500 $

relaxed policy = 99000 * .35

= 34650 $

net income = EBT -tax

net income under the

restricted policy = 115500 - 40425

= 75075$

medium policy = 110000-38500

= 71500 $

relaxed policy =99000 - 34650

= 64350 $

return on equity = Net income / common equity

ROE under the

restricted policy = 75075/855000

= 8.78%

medium policy = 71500/900000

= 7.94 %

relaxed policy = 64350/ 990000

= 6.5%

the assumption is not valid in the real scenario. companies current assets policies especially w.r.t to accounts receivables or debtors will show a significant impact on the sales. however, finding out an optimal current asset level is not possible in reality.

1) marketing team effort may help to boost sales but the credit terms given to debtors also decides the level of sales and the discount policies, collection policies and collection periods also impacts the sales. the marketing term using the above policies helps to increase sales

2) the long-term debt policies are affected by the firm because the rise and decrease in the current assets will decide the total assets which in turn reflects the level of equity and debt. high debt leads to high-interest payments and lowers the shareholder's funds which lead to fewer expansion plans.

3) no the level of fixed assets need not change necessarily due to the change in current asset policies.

4) I agree with the question 4 as the current asset policies play a vital role in the real world scenario as the discount policies, collection period, collection policies impact the current assets policies which in turn impact the sales of the firm.

5) the situation doesn't exist in the real world situation and it is not possible to find out the optimum current asset level and design a policy for the same

Under all the above-discussed policies risk differs with an increase in the level of equity and decrease in the level of debt. as debt gives a secured return to investors rather than the equity investment. at the same time companies return will be at stake .