Question

Big Retailer (BR) follows a moderate current asset investment policy, but is now considering a change, perhaps to a restricted or maybe to a relaxed policy. BR’s annual sales are $1,400,000; its fixed assets are $950,000; its target capital structure calls for 40% debt and 60% equity; its EBIT is $650,000; the interest rate on debt is 8%; and its tax rate is 20%. With a restricted policy, current assets will be 20% of sales, while under a relaxed policy, current assets will be 35% 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

Solution :- i). Under restricted policy:-

Current assets = 20 % of 1400000. (20 % of Annual sales)

= $ 280000

Fixed assets = $ 950000. (Given in the question).

Total assets = 280000 + 950000. (Current assets + Fixed assets).

= $ 1230000.

60 % of Total assets are financed through equity, therefore, Equity value = 1230000 * 60 % = $738000.

Debt value = Total assets - Equity value.

= 1230000 - 738000

= $ 492000.

Calculation of Net income of Big Retailer (BR) under restricted policy :-

Particulars	Amount ($)
EBIT (-) Interest on debt (492000 * 8 %)	650000 39360
Earnings before Tax (EBT) (-) Tax (20 % of 610640)	610640 122128
Net income	488512

Return on equity (under restricted policy) = (Net income / Total equity) * 100.

= (488512 / 738000) * 100

= 66.19 %

ii). Under relaxed policy:-

Current assets = 35 % of 1400000. (35 % of annual sales)

= $ 490000.

Fixed assets = $ 950000. (Given in the question).

Total assets = 490000 + 950000. (Current assets + Fixed assets)

= $ 1440000.

60 % of Total assets are financed through equity, therefore, Equity value = 1440000 * 60 % = $864000

Debt value = Total assets - Equity value.

= 1440000 - 864000

= $ 576000.

Calculation of Net income of Big Retailer (BR) under relaxed policy :-

Particulars	Amount ($)
EBIT (-) Interest on debt (576000 * 8 %)	650000 46080
Earnings before Tax (EBT) (-) Tax (20 % of 603920)	603920 120784
Net income	483136

Return on equity (under relaxed policy) = (Net income / Total equity) * 100

= (483136 / 864000) * 100

= 55.92 %

Difference between Return on equity (ROE) under restricted policy and relaxed policy = 66.19 % - 55.92 %

= 10.27 %

Conclusion :- Difference between ROE = 10.27 (Answer is in percent).

Alternatively, 10.27 % can also be written as 0.1027