Question

The Hawley Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of asset expansion presently been undertaken. Fixed assets total $1 million, and the firm finances 60% of its total assets with debt and the rest with equity. Hawley’s interest cost currently is 8% on both short term and longer term debt. Three alternatives regarding the projected current asset level are available to the firm: (1) A tight policy requiring current assets of only 45% of projected sales, (2) a moderate policy of 50% of sales as current asset level, and (3) a relaxed policy requiring current assets of 60% of sales. The firm expects to generate EBIT equal to 12% of sales.

a. What is the expected return on equity under each current asset level? (Assume 40% corporate tax rate)

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

c. How would the overall riskiness of the firm vary under each policy?

Answer 1

Return on Equity = Net Income / Total Equity

b) No, the expected sales is not independent of current assets. In fact, it is somewhat dependent on current assets.
For example, if you have higher inventory during peak season, then that will help to do achieve more sales as you already have the product in stock with you
And on the other hand, if the higher sales are done on credit then that will lead to higher accounts receivables which will increase the current assets

c) Higher current assets would mean the company is facing risk of inventory liquidation i.e. the company might have to sell off its inventory at lower levels in order to free up the capital and will lead to lower RoE also.
Higher the current assets, higher is the inventory risk and lower RoE and vice versa.