Sugar Corporation is considering what level of current assets to maintain, as well as whether to use more or less long-term debt, as opposed to short-term debt.Factors to consider:Fixed assets - $6,000,000Earnings before interest and taxes - $ 800,000Tax rate – 30 percentOptimal capital structure – 60 percent equity, 40 percent debtInterest on short-term debt – 5 percentInterest on long-term debt – 8 percentCurrent asset level possibilities. Aggressive - $1,000,000 Conservative - $1,500,000.Level of short-term debt possibilities. Aggressive – 70 percent of total debt.  Conservative – 40 percent of total debt. Required:Calculate the return on equity for the aggressive and conservative plans.Discuss which plan you would choose.

Question
Asked Dec 12, 2019
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Sugar Corporation is considering what level of current assets to maintain, as well as whether to use more or less long-term debt, as opposed to short-term debt.

Factors to consider:

  • Fixed assets - $6,000,000
  • Earnings before interest and taxes - $ 800,000
  • Tax rate – 30 percent
  • Optimal capital structure – 60 percent equity, 40 percent debt
  • Interest on short-term debt – 5 percent
  • Interest on long-term debt – 8 percent
  • Current asset level possibilities. Aggressive - $1,000,000 Conservative - $1,500,000.
  • Level of short-term debt possibilities. Aggressive – 70 percent of total debt.  Conservative – 40 percent of total debt.

 

Required:

  1. Calculate the return on equity for the aggressive and conservative plans.
  2. Discuss which plan you would choose.
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Expert Answer

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Step 1

1.

Calculation of Return on Equity:

The return on equity of aggressive plans is 10.58% and return on equity of conservative plans is 9.27%.

Excel Spreadsheet:

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1 Fixed Assets 2 Earninge Before Interest on Taxes 3 Tax Rate 4 Weight of Debt 5 Weight of Equity 6 Interest on Short-Term Debt 7 Interest on Long-Term Debt 8 Asset Level of Aggressive 9 Asset Level of Conservative 10 Weight of Short-Term Debt Level of Aggressive 11 Weight of Short-Term Debt Level of Conservative $6,000,000 S800,000 30% 40% 60% 5% 8% $1,000,000 $1,500,000 70% 40% 12 Aggressive Plans Conservative Plans S6,000,000 $1,000,000 $7,000,000 $7,000,000 $2,800,000 $4,200,000 S1,960,000 S840,000 13 Particulars 14 Value of Fixed Assets 15 Value of Asset Level 16 Value of Total Assets 17 Value of Total Liabilties 18 Value of Debt 19 Value of Equity 20 Value of Short-Term Debt 21 Value of Long-Term Debt $6,000,000 $1,500,000 $7,500,000 $7,500,000 $3,000,000 $4,500,000 $1,200,000 S1,800,000 22 Aggressive Plans Conservative Plans $800,000 $98,000 $67,200 $634,800 $190,440 $444,360 $4,200,000 23 Particulars 24 Earninge Before Interest on Taxes 25 Less: Interest on Short-Term Debt 26 Less: Interest on Long-Term Debt 27 Earnings Before Taxes 28 Less: Taxes at 30% 29 Earnings After Taxes 30 Value of Equity $800,000 S60,000 $144,000 $596,000 $178,800 $417,200 $4,500,000 Return on Equity 31 10.58% 9.27%

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Step 2

Excel Workings:

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A 1 Fixed Assets 2 Earninge Before Interest on Taxes 3 Tax Rate 4 Weight of Debt 5 Weight of Equity 6 Interest on Short-Term Debt 7 Interest on Long-Term Debt 8 Asset Level of Aggressive 9 Asset Level of Conservative 10 Weight of Short-Term Debt Level of Aggressive 11 Weight of Short-Term Debt Level of Conservative 0.4 6000000 800000 0.3 0.4 0.6 0.05 0.08 1000000 1500000 0.7 12 Aggressive Plans Conservative Plans -B1 13 Particulars 14 Value of Fixed Assets 15 Value of Asset Level 16 Value of Total Assets 17 Value of Total Liabilties 18 Value of Debt 19 Value of Equity =B1 -B9 -C14+C15 -B14+B15 =B16 C16 -C17*B4 =C17*B5 -B17*B4 =B17*B5 20 Value of Short-Term Debt B18*B10 C18*B11 21 Value of Long-Term Debt -B18-B20 -C18-C20 22 Particulars Aggressive Plans Conservative Plans |-B2 -C20*B6 -C21*B7 -C24-C25-C26 C27*B3 23 24 Earninge Before Interest on Taxes 25 Less: Interest on Short-Term Debt 26 Less: Interest on Long-Term Debt 27 Earnings Before Taxes -B2 -B20 B6 -B21"B7 -B24-B25-B26 =B27*B3 28 Less: Taxes at 30%

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