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 $40,000; 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 structure = 50% debt, 50% equity
So, Equity =	80000
Debt = 50% of 160000	80000
EBIT =	40000
Interest = 8% of debt
8% of 80000	6400
Tax rate =	25%
Net income = ( EBIT-Interest) * (1-tax rate)
(40000-6400)*(1-25%)=	25200
ROE formula = Net income / Equity
25200/80000=	0.315	or 31.50%
So, ROE under restricted policy is 31.50%
Relaxed policy
Sales =	400000
Current assets = 25 % of sales=	100000
Fixed Assets =	100000
Total Assets = Fixed assets + Current assets =	200000
Capital structure = 50% debt, 50% equity
So, Equity =	100000
Debt = 50% of 160000	100000
EBIT =	40000
Interest = 8% of debt
8% of 80000	8000
Tax rate =	25%
Net income = ( EBIT-Interest) * (1-tax rate)
(40000-8000)*(1-25%)=	24000
ROE formula = Net income / Equity
24000/100000=	0.24	or 24%
So, ROE under relaxed policy is 24%
Under Restricted policy ROE is 31.50% while under Relaxed policy is 24%. so there is
difference of 7.50% in RoE. ROE is more in case of Restricted policy. So this is favourable..