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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

CURRENT ASSETS INVESTMENT POLICY 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 $1 million, and the firm plans to maintain a 60% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short- 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. a. What is the expected return on equity under each current assets level?
  2. b. ln this problem, we assume: that expected sales are independent of the current assets investment policy. Is this a valid assumption? Why or why not?
  3. c. How would the firm's risk be affected by the different policies?

a.

Summary Introduction

To determine: The expected return on equity under each current assets level.

Introduction:

Return on Equity:

The return on equity refers to a part or portion of the net income which is returned as a certain percentage of the equity to the shareholder. This is also a profitability measuring ratio.

Explanation

Given information:

The amount of expected sales is $2 million.

The amount of fixed assets is $1 million.

The debt to assets ratio to be maintained is 60%.

The interest rate is 8% on both short-term and long-term debt.

Three alternatives are considered which have following conditions:

The restricted policy where current assets would be 45% of the projected sales.

The moderate policy where current assets would be 50% sales.

The relaxed policy where current assets would be 60% of sales.

The earnings before interest and taxes must be 12% of total sales

The federal plus state tax rate is 40%.

Calculate the return on equity.

The formula to calculate the return on equity is,

Returnonequity=NetincomeEquity

For the tight policy,

Substitute $89,280 for the net income and $760,000 for the equity (refer working note).

Returnonequity=$89,280$760,000=0.1175or11.75%

The return on equity for tight policy is 11.75%.

For the moderate policy,

Substitute $86,400 for the net income and $800,000 for the equity (refer working note).

Returnonequity=$86,400$800,000=0.108or10.8%

The return on equity for moderate policy is 10.8%.

For the relaxed policy,

Substitute $80,640 for the net income and $880,000 for the equity (refer working note)

b.

Summary Introduction

To explain: Whether the assumption of expected sales being independent of the current assets is valid or not and the reasons for it.

c.

Summary Introduction

To determine: The effect on the risk of the firm by different policies.

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