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

		Current Asset Policy
		Tight	Moderate	Relaxed
	Current asset level as % of sales	45%	50%	60%
	Fixed assets	$      1,000,000	$      1,000,000	$     1,000,000
	Current assets	$         900,000	$      1,000,000	$     1,200,000
	Total assets	$      1,900,000	$      2,000,000	$     2,200,000
	Equity [40%]	$         760,000	$ 800,000	$        880,000
	Debt [60%]	$      1,140,000	$      1,200,000	$     1,320,000
	Total liabilities & equity	$      1,900,000	$      2,000,000	$     2,200,000
	EBIT [2000000*12%]	$         240,000	$ 240,000	$        240,000
	Interest on debt at 8%	$ 91,200	$ 96,000	$        105,600
	EBT	$         148,800	$ 144,000	$        134,400
	Tax at 40%	$ 59,520	$ 57,600	$ 53,760
	NI	$ 89,280	$ 86,400	$ 80,640
	ROE [NI/Equity]	11.75%	10.80%	9.16%
b]	No, the assumption is not valid. The reasons are:
	*Extent of credit, which decides the average AR outstanding and hence the total current assets, influences sales.
	*Not having adequate inventories can create loss of production and sales.
	Hence, level of current assets can influence sales.
c]	As EBIT remains the same the degree of operating leverage is the same and hence
	there is no operating risk.
	But, the three policies require different levels of debt. Having higher debt
	increases the financial leverage [financial risk] of the firm.
	Hence, the relaxed policy having higher debt has higher financial risk than the others.