Question

Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $4 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 50% debt-to-assets ratio. Rentz's interest rate is currently 10% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 14% of total sales, and the federal-plus-state tax rate is 40%.

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

   Restricted policy		%
   Moderate policy		%
   Relaxed policy		%

Answer 1

Return on equity is equal to return earned by the company on shareholders equity
Formula to calculate return on equity
ROE = Income applicable to equity shareholder's/Number of shares outstanding
Calculation of ROE is shown below
	Restricted Policy	Moderate Policy	Relaxed policy
Fixed assets	$1,000,000	$1,000,000	$1,000,000
Current assets	$1,800,000	$2,000,000	$2,400,000
	4000000*45%	4000000*50%	4000000*60%
Total assets	$2,800,000	$3,000,000	$3,400,000
Debt (50%)	$1,400,000	$1,500,000	$1,700,000
Equity (50%)	$1,400,000	$1,500,000	$1,700,000
Calculation of net income
EBIT	$560,000	$560,000	$560,000
	4000000*14%	4000000*14%	4000000*14%
Less: Interest	$140,000	$150,000	$170,000
	1400000*10%	1500000*10%	1700000*10%
Earnings before tax (EBIT-Interest)	$420,000	$410,000	$390,000
Tax @ 40%	$168,000	$164,000	$156,000
Net Income	$252,000	$246,000	$234,000
Return on Equity	18.00%	16.40%	13.76%
	252000/1400000	246000/1500000	234000/1700000
Expected return on equity
Restricted policy	18.00%
Moderate policy	16.40%
Relaxed policy	13.76%