Problem 15-8 Current assets investment policy Rentz Corporation is investigating
ID: 2612783 • Letter: P
Question
Problem 15-8
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 $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 40% debt-to-assets ratio. Rentz's interest rate is currently 8% 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 14% of total sales, and the federal-plus-state tax rate is 40%.
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 %Explanation / Answer
(1) Restricted Policy.
Current asset (CA) = 45% x projected sales = 45% x $2 million
= $900,000
Fixed asset (FA) = $1 million
Total assets (TA) = CA + FA = $1,900,000
Debt = Debt-to-Assets ratio x TA = 40% x $1,900,000 = $760,000
So, equity = Assets - Debt = $(1,900,000 - 760,000) = $1,140,000
Interest on debt = $760,000 x 8% = $60,800
EBIT = Sales x 14% = $280,000
EBT = EBIT - Interest = $219,200
Net income = EBT x (1 - tax rate) = $219,200 x 0.6 = $131,520
So, ROE = Net Income / Equity = $131,520 / $1,140,000 x 100 = 11.54%
(2) Moderate policy:
Current asset (CA) = 50% x projected sales = $1 million
Fixed asset (FA) = $1 million
Total assets (TA) = CA + FA = $2,000,000
Debt = Debt-to-Assets ratio x TA = 40% x $2,000,000 = $800,000
So, equity = Assets - Debt = $(2,000,000 - 800,000) = $1,200,000
Interest on debt = $800,000 x 8% = $64,000
EBIT = Sales x 14% = $280,000
EBT = EBIT - Interest = $216,000
Net income = EBT x (1 - tax rate) = $216,000 x 0.6 = $129,600
So, ROE = Net Income / Equity = $129,600 / $1,200,000 x 100 = 10.80%
(3) Relaxed Policy
Current asset (CA) = 60% x projected sales = $1.2 million
Fixed asset (FA) = $1 million
Total assets (TA) = CA + FA = $2,200,000
Debt = Debt-to-Assets ratio x TA = 40% x $2,200,000 = $880,000
So, equity = Assets - Debt = $(2,200,000 - 880,000) = $1,320,000
Interest on debt = $880,000 x 8% = $70,400
EBIT = Sales x 14% = $280,000
EBT = EBIT - Interest = $209,600
Net income = EBT x (1 - tax rate) = $209,600 x 0.6 = $125,760
So, ROE = Net Income / Equity = $125,760 / $1,320,000 x 100 = 9.53%