What is the expected return on equity under each current asset level? In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption? Why or why not? How would the firm’s risk be affected by the different policies?
Atlas Corporation wants to determine the optimal level of current assets that should be kept in the next year. The company is currently undergoing expansion, after which sales are expected to increase approximately by PKR 1 million. The company wants to maintain a 40% equity ratio and its total fixed assets are of PKR 1 million. Atlas’s interest rate is currently 8% on both short-term and longer-term debt (which the firm uses in its permanent structure). The company must choose between three strategies and decide which one is better.
(1) a lean and mean policy where current assets would be only 35% of projected sales, (2) a moderate policy where current assets would be 40% of sales, and (3) a lenient policy where current assets would be 50% of sales. Earnings before interest and taxes should be 10% of total sales, and the federal-plus-state tax rate is 35%.
- What is the expected
return on equity under each current asset level? - In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption? Why or why not?
- How would the firm’s risk be affected by the different policies?
- A good current and quick ratio are a guarantee of excellent working capital management strategies. Is this a valid assumption? Why or why not?
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