Question

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 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 11% of total sales, and the federal-plus-state tax rate is 40%.

1. 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		%

2. 
   
3. In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption?
   1. Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.
   2. 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.
   3. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.
   4. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.
   5. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.
   
   -Select-IIIIIIIVVItem 4
4. 
   
5. 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

a…	(1)Restricted policy-current assets=45%*sales	2.Moderate policy-current assets=50 %*sales	2.Relaxed policy-current assets=60 %*sales
Sales	4	4	4
EBIT(sales*11%)	0.44	0.44	0.44
Less:Interest(debt*10%)	-0.24	-0.25	-0.27
EBT	0.2	0.19	0.17
Less: Tax at 40%(EBT*40%)	-0.08	-0.076	-0.068
EAT/Net Income	0.12	0.114	0.102
Assets:
Current assets	1.8	2	2.4
Add:Fixed assets	3	3	3
Total assets	4.8	5	5.4
Debt(Total assets*50%)	2.4	2.5	2.7
Equity(Total assets-Debt)	2.4	2.5	2.7
ROE=Net Income/Total Equity	5.00%	4.56%	3.78%

In the above, ROE decreases as the current assets/sales % increase.

so, the level of current assets , do affect the sales performance.

the lower(or optimal) the level of current assets to sales, the higher will be the ROE,as it adds to make the total assets --which if more than the optimum, will reduce the asset turnover--ie. $ sales generated per $ of asset utilised.

That said, Answer to c. will be

II. 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.

Increase in sales is made possible only by adequate increases in both fixed & current assets as well as incurring current liabilities.

Increased sales need to be supported by increased inventory of finished goods--which, in its turn needs increased inventory of raw materials.

Also due to increase in sales ,cash & receivables increase along with some prepaid assets for operating expenses like insurance, rent, advertising, etc.

So, the ploicy to hold which level of inventory or cash & receivables as working capital --all have its significant effect on sales. A tight working capital policy , will not help to increase sales.

e. How would the firm's risk be affected by the different policies?

Risk is associated with debt.Risk means risk of default in paying periodic interest on debt & having liquid funds to pay on maturity , the risk of inflation eating into the money value--all goes up as debt increase in the balance sheet.

The more the current assets, the more the total assets & the more the debt proportion , in the capital structure.

In the given case, as current assets increase,debt & the addendent risks, as dealt above , also increase .

The risk is the least under restricted current asset policy (45%) and the maximum under relaxed current assets policy (60%)--because , the firm needs to incur more debt , to fund the increased current asset--- which in turn, is needed to support the increased sales.