Question

Muscarella Inc. has the following balance sheet and income statement data: Cash $ 14,000 Accounts payable $ 42,000 Receivables 70,000 Other current liabilities 28,000 Inventories 210,000 Total CL $ 70,000 Total CA $294,000 Long-term debt 70,000 Net fixed assets 126,000 Common equity 280,000 Total assets $420,000 Total liab. and equity $420,000 Sales $280,000 Net income $ 21,000 The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 3.10, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change? Select the correct answer. a. 3.43% b. 4.02% c. 4.61% d. 2.84% e. 2.25%

Answer 1

Step 1-Actual position without selling stock

Liability	Amount	Assets	Amount
Equity	280000	Cash	14000
Long Term Debt	70000	Accounts Receivables	70000
Accounts Payable	42000	Inventory	210000
Other Current Liability	28000	Fixed Assets	126000
TOTAL	420000	TOTAL	420000

Step 2-Current situaion of Current Ratio of Muscarella Inc.

Current Ratio=Current Assets/Current Liabilities

where,

Current Assets=294000

Current Liabilities= 70000

Current Ratio=294000/70000=4.20

Step 3-Required Current Ratio is 3.10

Therefore,

Change in Current Ratio=Change in Current Assets/Current Liabilities

4.20-3.10=Change in Current Assets/70000

1.1*70000=Change in Current Assets=77000

Hence Excessive Inventories to the value $77000 will be sold & its proceeds will be ustilised for buy back without impacting net income since these inventories are sold at cost.

Hence New Inventory Position will be 210000-77000 ie $133000

& Common Equity will be 280000-77000=$203000

Step 4-Change in Return on Equity

Formula=Net Income/Common Equity*100

	OLD POSITION	NEW POSITION
NET INCOME	21000	21000
COMMON EQUITY	280000	203000
RETURN ON EQUITY	21000/280000*100=7.50%	21000/203000*100=10.34%

Hence change of 10.34-7.50=2.84% ie OPTION D