Question

Buchholz Corporation follows a moderate current asset investment policy, but is now considering a change, perhaps to a restricted or maybe 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 $50,000; the interest rate on debt is 8%; and its tax rate is 25%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy, current assets will be 25% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? Enter your answer rounded to two decimal places. Do not enter % in the answer box. For example, if your answer is 0.12345 or 12.345% then enter as 12.35 in the answer box.    

Answer 1

Restricted policy

Sales = 400000

Current assets = 15 % of sales= 60000

Fixed Assets = 100000

Total Assets = Fixed assets + Current assetes = 160000

Capital strucuture = 50% debt, 50% equity

So, Equity = 80000

Debt = 50% of 160000 =80000

EBIT = 50000

Interest = 8% of debt

8% of 80000 6400

Tax rate = 25%

Net income = ( EBIT-Interest) * (1-tax rate)

(50000-6400)*(1-25%)

= $32700

ROE formula = Net income / Equity

32700/80000= 0.40875 or 40.88%

So, ROE under restricted policy is 40.88%

Relaxed policy

Sales = 400000

Current assets = 25 % of sales= 100000

Fixed Assets = 100000

Total Assets = Fixed assets + Current assetes = 200000

Capital strucuture = 50% debt, 50% equity

So, Equity = 100000

Debt = 50% of 160000 100000

EBIT = 50000

Interest = 8% of debt

8% of 100000 8000

Tax rate = 25%

Net income = ( EBIT-Interest) * (1-tax rate)

(50000-8000)*(1-25%)= 31500

ROE formula = Net income / Equity

31500/100000= 0.315 or 31.5%

So, ROE under relaxed policy is 31.5%

Under Restricted policy ROE is 40.88% while under Relaxed policy is 31.50%. so there is difference of 9.38% in RoE. Roe is more in case of Restricted policy. So this is favourable.