Question

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 $3 million as a result of an asset expansion presently being undertaken. Fixed assets total $3 million, and the firm plans to maintain a 55% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short-term 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% a. What is the expected return on equity under each current assets 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. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales. II. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs. III. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm. IV. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets. V. 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. -Select- c. How would the firm's risk be affected by the different policies? The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Answer 1

The shareholders' equity = company’s assets - debt

Sales	3000000
Debt to asset	55%
Equity to asset	45%	1-55%
EBIT(12% of sales)	360000	12%*3000000
Policy	Restricted	Moderate	Relaxed
Current asset	45%	50%	60%
Current asset	1350000	1500000	1800000
Fixed asset	3000000	3000000	3000000
Total asset	4350000	4500000	4800000
Debt (Asset*55%)	2392500	2475000	2640000
Equity (Asset*45%)	1957500	2025000	2160000
EBIT	360000	360000	360000
Interest (8% of debt)	-191400	-198000	-211200
EBT	168600	162000	148800
Tax(40%)	-67440	-64800	-59520
EAT	101160	97200	89280
	Restricted	Moderate	Relaxed
ROE (EAT/Equity)	5.168%	4.800%	4.133%

Answer b)

Option V. 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.

Answer c) The return on equity depend on the policy , which impact the amount of risk.