Question

The Calgary Company is attempting to establish a current assets policy. Fixed assets are

$600,000, and the firm plans to maintain a 40 percent debt-to-assets ratio. Calgary has no operating current liabilities. The interest rate is 12 percent on all debt. Three alternative current asset policies are under consideration: 40, 50, and 60 percent of projected sales. The company expects to earn 18 percent before interest and taxes on sales of $6 million. Calgary’s effective tax rate is 40 percent.

1. What is the expected return on equity under each alternative?
2. Evaluate ROE from owner point of view and suggest which option is best for him?
3. Suggest which option would you like if you are managers of the company and do not have much concern about business?
4. Why current assets policy is important in this particular situation?

Answer 1

(i) &(ii)

ROE UNDER 3 DIFFRENT OPTIONS

SCENARIO1 : CURRENT ASSETS 40% TO SALES

Total Assets= Fixed assets+current assets

Total assets= 600,000+ 40%($6M)

Total Assets= 600,000+2,400,000=3,000,000

Total Debt is 40% of $3M i.e 1.2M

Given EBIT = 1,080,000 ($6M*18%)

INTREST = (144,000)(1.2M*12%)

EBT = 936,000

TAX = (374,400)

Net proft = 5,61,600

therefore ROE =5,61,600/1,800,000(60% of Total Assets i.e 3M*60%)

ROE= 31.2%

SCENARIO2:- Current Assets 50% to Sales

Total assets= 600,000+ 50%($6M)

Total assets= $3,600,000

Total Debt is 40% of $3.6M i.e $1,440,000

Given EBIT = 1,080,000 ($6M*18%)

Inerest = 172,800)

EBT = 907,200

TAX = (3,62,880)

Net Profit = 5,44,320

ROE = 5,44,320/2,160,000((60% of Total Assets i.e 3.6M*60%)

25.20%

SCENARIO3: Current Assets 60% to Sales

Total Assets= 600,000+3,600,000= 4,200,000

Total Debt = 40% of 4.2M= 1,680,000

Given EBIT = 1,080,000 ($6M*18%)

INTREST = (201,600)(1.68M*12%)

EBT = 878,400

TAX = (351,360)

Net proft = 5,27,040

therefore ROE =5,27,040/2,520,000(60% of Total Assets i.e 4.2M*60%)

ROE= 20.91%

iii)

As a manager I would suggest, to give more return to equity shareholders therefore having current assets 40% to sales is suggestable i.e scenario1

(iv) In this situataion current asset policy is important because it is the deciding factor to decide the Debt of the company so that comapanies fixed committement i.e intrest is based on.