Question

Fleda's Beauty Company has $200,000 of total assets and earns 20 percent interest and taxes on these assets. The ratio of total debts to total assets (or DR been set at 50 percent. The interest rate on short-term debt is 7 percent, while the interest rate on long-term debt is 10 percent. A conservative policy calls for only long-term debt with no short-term debt; an intermediate policy calls for 50 percent short-term debt and 50 percent long-term debt; and an aggressive policy calls for 100 percent short-term debt and no long-term debt. The firm's tax rate is 50 percent (a) What is the rate of return on equity under each of these three policies? (b) If current assets are 50 percent of total assets, what is the current ratio unde each of these three policies?

Answer 1

Note: As per answering guidelines, only the first question has been answered.

Note 1: Calculation of interest expense: Formula Total Assets Given in the question Debt to Assets ratio Given in the question Total Assets * Debt to Total debt assets ratio Conservative 2,00,000 50% Intermediate 2,00,000 50% Aggressive 2,00,000 50% 1,00,000 1,00,000 1,00,000 Breakdown of debt in %: - Long-term debt - Short-term debt 100% 0% Given in the question Given in the question 50% 50% 0% 100% Breakdown of debt in $: - Long-term debt - Short-term debt 1,00,000 Total debt* breakdown % Total debt* breakdown % 50,000 50,000 1,00,000 Interest expense: - Long-term debt - Short-term debt 10,000 Long-term debt* 10% Short-term debt*7% 5,000 3,500 7,000 Total interest expense Long-term debt interest + Short-term debt interest 10,000 8,500 7,000

Solution (a) - Calculation of Return on Equity: Formula Total Assets Given in the question EBIT % Given in the question Earnings before interest and taxes Total Assets *EBIT% Interest expense As calculated in Note 1 Earnings before taxes (EBT) EBIT-Interest expense Taxes EBT*50% Earnings after taxes EBT-Taxes | Conservative 2,00,000 20% 40,000 10,000 30,000 15,000 15,000 Intermediate 2,00,000 20% 40,000 8,500 31,500 15,750 15,750 Aggressive 2,00,000 20% 40,000 7,000 33,000 16,500 16,500 Total debt Equity Shareholders funds 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 As calculated in Note 1 Total assets - Total debt (Earnings after taxes/Equity shareholders funds)*100 Return on Equity (ROE) 15.00% 15.75% 16.50% Solution (b)- Calculation of Current Ratio: Formula Conservative 2,00,000 Intermediate 2,00,000 Aggressive 2,00,000 Total Assets Ratio of current assets to total assets Given in the question 50% 50% 50% Current Assets Total Assets * Ratio of current assets 1,00,000 1,00,000 1,00,000 As calculated in Note 1 Short-term debt (considered equal to current liabilities in absence of any more information) Current Ratio 50,000 1,00,000 Current Assets/Current liabilities Not defined 2