Question

Galaxy Company is thinking of modifying its current assets investment policy. Fixed assets are
$600,000, sales are projected at $3 million, the EBIT/Sales ratio is projected at 15%, the interest
rate is 10% on all debt, the federal plus-state tax rate is 40%, and Galaxy plans to maintain a 50%
debt-to-assets ratio. Three alternative current assets investment policies are under consideration:
40%, 50%, and 60% of projected sales. What is the expected return on equity under each
alternative?

Answer 1

Sol:

To determine expected return on equity under each alternative is as follows:
	Particulars	Level 1	Level 2	Level 3
	Sales	$3,000,000	$3,000,000	$3,000,000
	Current assets (CA)	$1,200,000	$1,500,000	$1,800,000
	Fixed assets (FA)	$600,000	$600,000	$600,000
	Total assets (CA + FA)	$1,800,000	$2,100,000	$2,400,000
	Debt	$900,000	$1,050,000	$1,200,000
	EBIT (15% os sales)	$450,000	$450,000	$450,000
Less	Interest on debt (10% on debt)	$90,000	$105,000	$120,000
	EBT	$360,000	$345,000	$330,000
Less	Tax (40%)	$144,000	$138,000	$132,000
	Net income (NI)	$216,000	$207,000	$198,000
	Equity (Total assets - Debt)	$900,000	$1,050,000	$1,200,000
	Return on equity (NI/Equity*100)	24%	19.71%	16.5%

Therefore expected return on equity under alternative Level 1 is 24%, Level 2 is 19.71% and Level 3 is 16.5%