Question

Rentz 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 $1 million, and the firm plans to maintain a 45% debt-to-assets ratio. Rentz's interest rate is currently 8% 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%. 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 % In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption? Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets. 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. c. How would the firm's risk be affected by the different policies? The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Answer 1

a).

	Tight	Moderate	Relaxed
Current Assets	$1,800,000	$2,000,000	$2,400,000
Fixed Assets	$1,000,000	$1,000,000	$1,000,000
Total Assets	$2,800,000	$3,000,000	$3,400,000
Debt (45% x Total Assets)	$1,260,000	$1,350,000	$1,530,000
Equity(Total Assets - Debt)	$1,540,000	$1,650,000	$1,870,000
Total Liabilities and Equity	$2,800,000	$3,000,000	$3,400,000
EBIT(10% x $4,000,000)	$400,000	$400,000	$400,000
Less: Interest (8% x Total Debt)	$100,800	$108,000	$122,400
EBT	$299,200	$292,000	$277,600
Less: Taxes (@40%)	$119,680	$116,800	$111,040
Net Income	$179,520	$175,200	$166,560
ROE(Net Income / Equity)	11.66%	10.62%	8.91%

b). This is not a valid assumption because a firm’s current asset polices may significantly effect sales. It is difficult to determine an optimal current asset level and may not even be possible.

c). The tighter the policy the higher the expected returns. As the current asset level decreases it might

seem that the difference is from accounts receivable. It could be accomplished with higher discounts

and a shorter collection period as well. Tighter receivable polices could create additional costs but

would most likely reduce bad debt expenses. Lower inventories could cause a multitude of operational

problems and could mean lost sales