Question

Jasper Enterprises follows a moderate current asset investment policy, but it is now considering whether to shift to a restricted or perhaps to a relaxed policy. The firm’s annual sales are $400,000, its fixed assets are $100,000, its target capital structure calls for 50% debt and 50% equity, its EBIT is $35,000, the interest rate on its debt is 10%, and its tax rate is 40%. With a restricted policy, current assets will be 20% of sales, while under a relaxed policy they will be 30% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies?

Answer 1

Sales = 400,000 | Fixed Assets = 100,000

Target D/E = 50% | EBIT = 35,000

Interest Rate = 10% | Tax rate = 40%

=> Restricted Policy

Current Assets = 20% of Sales = 20% * 400,000 = 80,000

With Fixed Assets given, Total Assets = Current Assets + Fixed Assets = 80,000 + 100,000 = 180,000

Since Target Debt to Equity ratio = 50%

Hence, Debt = 50% of Total Assets = 50% * 180,000 = 90,000

Equity = Total Assets - Debt = 180,000 - 90,000 = 90,000

Now we will calculate Net Income for the restricted policy scenario

Net Income = (EBIT - Interest Expense)*(1 - tax rate)

Since Interest rate is 10% and Debt is 90,000, hence, Interest Expense = 10% * 90,000 = 9,000

Net Income = (35,000 - 9,000) * (1 - 40%) = 26,000 * 0.6 = 15,600

Now we will calculate Return on Equity using Net Income / Equity formula

Return on Equity = 15,600 / 90,000 = 17.33%

=> Relaxed Policy

Current Assets = 30% of Sales = 30% * 400,000 = 120,000

With Fixed Assets given, Total Assets = Current Assets + Fixed Assets = 120,000 + 100,000 = 220,000

Since Target Debt to Equity ratio = 50%

Hence, Debt = 50% of Total Assets = 50% * 220,000 = 110,000

Equity = Total Assets - Debt = 220,000 - 110,000 = 110,000

Now we will calculate Net Income for the restricted policy scenario

Net Income = (EBIT - Interest Expense)*(1 - tax rate)

Since Interest rate is 10% and Debt is 110,000, hence, Interest Expense = 10% * 110,000 = 11,000

Net Income = (35,000 - 11,000) * (1 - 40%) = 24,000 * 0.6 = 14,400

Now we will calculate Return on Equity using Net Income / Equity formula

Return on Equity = 14,400 / 110,000 = 13.09%

Difference in Projected ROEs between both the policies = Restricted Policy ROE - Relaxed Policy ROE

Difference in Projected ROEs = 17.33% - 13.09% = 4.24%

Hence, Difference in Projected ROEs between both the policies = 4.24%