Question

he 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

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