Question

Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $3 million as a result of an asset expansion presently being undertaken. Fixed assets total $3 million, and the firm plans to maintain a 40% debt-to-assets ratio. Rentz'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 13% 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?

Answer 1

LET US CALCULATE THE CURRENT ASSETS FOR ALL THE THREE POLICIES

CURRENT ASSETS = % OF ESTIMATED SALES

RESTRICTED POLICY	45%	3000000	1350000
MODERATE POLICY	50%	3000000	1500000
RELAXED POLICY	60%	3000000	1800000

TABLE SHOWING EXPECTED RETURN ON EQUITY UNDER THREE POLICIES:

PARTICULARS	RESTRICTED	MODERATE	RELAXED
current assets	1350000	1500000	1800000
fixed assets	3000000	3000000	3000000
total assets	4350000	4500000	4800000
debt(40% of TOTAL assets)	1740000	1800000	1920000
equity	2610000	2700000	2880000
total debt and equity shareholders fund	4350000	4500000	4800000
earnings before interest and tax (13% on sales)	390000	390000	390000
interest (10% on long and short-term debt)	(174000)	(180000)	(192000)
earnings before tax	216000	210000	198000
tax @ 40%	(86400)	(84000)	(79200)
net income	129600	126000	118800
return on equity**	4.97%	4.67%	4.13%

*equity= total assets - debt

**return on equity = net income/ equity

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