Question

A corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $4 million as a result of an asset expansion presently being undertaken. Fixed assets total $3 million, and the firm plans to maintain a 50% debt-to-assets ratio. The corp's interest rate is currently 10% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 10% of total sales, and the federal-plus-state tax rate is 40%.

1. What is the expected return on equity under each current assets level? Round your answers to two decimal places.
   

   Restricted policy		__%
   Moderate policy		__%
   Relaxed policy		__%

2. 
   
3. In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption?
   1. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.
   2. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.
   3. No, this assumption would probably not be valid in a real world situation. A firm's current asset policies may have a significant effect on sales.
   4. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.
   5. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.

Answer 1

	Restricted	Moderate	Relaxed
Current Assets	1,800,000	2,000,000	2,400,000
Fixed Assets	3,000,000	3,000,000	3,000,000
Total Assets	4,800,000	5,000,000	5,400,000
Debt	2,400,000	2,500,000	2,700,000
Equity	2,400,000	2,500,000	2,700,000
EBIT	400,000	400,000	400,000
Less: Interest	240,000	250,000	270,000
EBT	160,000	150,000	130,000
Less: Taxes	64,000	60,000	52,000
Net Income	96,000	90,000	78,000
Equity	2,400,000	2,500,000	2,700,000
ROE	4.00%	3.60%	2.89%
III.No, this assumption would probably not be valid in a real world situation. A firm's current asset policies may have a significant effect on sales.