Problem 16-8 Current assets investment policy Rentz Corporation is investigating
ID: 2483468 • Letter: P
Question
Problem 16-8 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 $4 million as a result of an asset expansion presently being undertaken. Fixed assets total $3 million, and the firm plans to maintain a 50% debt-to-assets ratio. Rentz's interest rate is currently 10% on both short-term and longer-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current asset 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 asset 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? I.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. II.Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales. III.Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs. IV.Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm. V.Yes, the current asset policies followed by the firm mainly influence the level of fixed assets. -Select-IIIIIIIVV c. How would the firm's risk be affected by the different policies?
Explanation / Answer
a) ROE for the three alternative current asset investment policy: Restricted Moderate Relaxed EBIT (11% of 4,000,000) 440000 440000 440000 Interest on debt at 10% 240000 250000 270000 EBT 200000 190000 170000 Tax @ 40% 80000 76000 68000 Net Income 120000 114000 102000 ROE 5.00% 4.56% 3.78% Workings: Total Assets: Fixed assets 3000000 3000000 3000000 current assets 1800000 2000000 2400000 Total Assets: 4800000 5000000 5400000 Financed by: Debt 2400000 2500000 2700000 Equity 2400000 2500000 2700000 b) I.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. c) Under the restricted policy the firm runs the risk of having operations restricted by the lower level of current assets. But the debt level and the interest on debt are lower. For the relaxed policy operational risk is less, but financial risk increases in terms of higher debt and interest payments.