Question

In: Finance

Cash $ 10,000 Accounts payable $ 30,000 Receivables 50,000 Notes payable 20,000 Inventories 150,000 Total current liabilities $ 50,000...

Cash	$ 10,000	Accounts payable	$ 30,000
Receivables	50,000	Notes payable	20,000
Inventories	150,000	Total current liabilities	$ 50,000
Total current assets	$ 210,000	Long-term debt	50,000
Net Fixed assets	90,000	Common equity	200,000
Total assets	$ 300,000	Total liabilities and equity	$ 300,000

Net Sales	200,000
Net income	15,000

Lloyd Inc. Has sales of $200,000, a net income of $15,000 (balance sheet posted above). The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 2.5x, without affecting sales or net income. If inventories are sold and not replaced (thus reducing the current ratio to 2.5x); if the funds generated are used to reduce common equity )stock can be repurchased at book value); and if no other changes occur, by how much will the ROE change? What will be the firm's new quick ratio?

How much will the ROE change?

What will be the firm’s new quick ratio?

Expert Solution

Answer :

Calculation of Existing ROE

Existing ROE = Net Income / Equity shareholder's Fund

= 15000 / 200000

= 0.075 or 7.5%

To calculate reduction in Inventory , we need to calculate the value of Current Assets using Current Ratio

Current Ratio = Current Assets / Total Current Liabilities

2.5 = Current Assets / 50000

==>Required Current Assets = 50000 * 2.5 = 125,000

So Reduction in Inventory = Existing Current Assets - Required Current Assets

= 210,000 - 125,000

= 85000

Calculation of New ROE when the funds are used to repurchase Common Equity

ROE = 15000 / (200,000 - 85000)

= 15000 / 115000

= 0.1304 or 13.04%

Change in ROE = 13.04% - 7.5% = 5.54% (Increase)

Calculation of Quick Ratio = Quick Assets / Current Liabilities

= (Cash + Receivables) / Current Liabilities

Note : Cash and Receivable balance will be same in existing as well as required situation.

= (10000 + 50000) / 50000

= 60000 / 50000

= 1.20x

jeff jeffy answered 1 year ago

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