Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $4 million as a result of an asset expansion presently being undertaken. Fixed assets total $2 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentz's interest rate is currently 8% 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 11% of total sales, and the federal-plus-state tax rate is 40%.
a. 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:
b. In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption? Select an option:
1: Yes, the current asset policies followed by the firm mainly
influence the level of long-term debt used by the firm.
2: Yes, the current asset policies followed by the firm
mainly influence the level of fixed assets.
3: 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.
4: Yes, this assumption would probably be valid in a real world
situation. A firm's current asset policies have no significant
effect on sales.
5: Yes, sales are controlled only by the degree of marketing effort
the firm uses, irrespective of the current asset policies it
employs.
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