Question

Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $2 million, and the firm plans to maintain a 55% debt-to-assets ratio. Rentz's interest rate is currently 9% 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 12% of total sales, and the federal-plus-state tax rate is 40%.

1. 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		%

2. 
   
3. In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption?
   1. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.
   2. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.
   3. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.
   4. 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.
   5. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.
   
   -Select-

Answer 1

Part a)

EBIT = Sales *12% = $2million*12% = $240,000

Sl.No	Particulars	Restricted policy	Moderate policy	Relaxed policy
i	% on sales (given)	45%	50%	60%
ii	Current assets (Sales*i)	$900,000	$1,000,000	$1,200,000
iii	Debt (ii*55%)	$495,000	$550,000	$660,000
iv	Interest on debt (iii*9%)	$44,550	$49,500	$59,400
v	EBIT (Refer above)	$240,000	$240,000	$240,000
vi	EBT (v-iv)	$195,450	$190,500	$180,600
vii	Tax @ 40% (vi*0.4)	$78,180	$76,200	$72,240
viii	Net income (vi-vii)	$117,270	$114,300	$108,360
ix	Equity (ii-iii)	405,000	450,000	540,000
x	Expected ROE (viii/ix)	28.96%	25.40%	20.07%

part c)

ii) Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.