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 $2 million, and the firm plans to maintain a 60% 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 14% 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, the current asset policies followed by the firm mainly influence the level of fixed assets. 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. III. Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales. IV. Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs. V. Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm. -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

a]	INCOME STATEMENT:	Restricted	Moderate	Relaxed
	Sales	$                   30,00,000	$            30,00,000	$        30,00,000
	EBIT [14%]	$                     4,20,000	$              4,20,000	$          4,20,000
	Interest at 8%	$                     1,60,800	$            1,68,000	$          1,82,400
	EBT	$                     2,59,200	$              2,52,000	$          2,37,600
	Tax at 40%	$                     1,03,680	$              1,00,800	$             95,040
	NI	$                     1,55,520	$              1,51,200	$          1,42,560
	ROE	11.61%	10.80%	9.38%
	BALANCE SHEET:
	Fixed assets	$                   20,00,000	$           20,00,000	$        20,00,000
	Current assets	$                   13,50,000	$           15,00,000	$        18,00,000
	Total assets	$                   33,50,000	$           35,00,000	$        38,00,000
	Debt [60%]	$                   20,10,000	$           21,00,000	$        22,80,000
	Equity [40%]	$                   13,40,000	$           14,00,000	$        15,20,000
	Total liabilities & equity	$                   33,50,000	$           35,00,000	$        38,00,000
b]	Option II.
	No, this assumption would probably not be valid in real world situation.
	A firm's current asset policies may have a significant effect on sales.
c]	Financial leverage [EBIT/EBT]	1.62	1.67	1.77
	Higher the debt higher the risk as indicated by the financial leverage. Hence, the
	relaxed policy has the highest risk and the restricted policy has the lowest risk.