Question

eBook Problem Walk-Through Lloyd Inc. has sales of $100,000, a net income of $7,000, and the following balance sheet: Cash $ 17,400 Accounts payable $ 31,030 Receivables 49,010 Notes payable to bank 15,950 Inventories 130,500 Total current liabilities $ 46,980 Total current assets $196,910 Long-term debt 48,140 Net fixed assets 93,090 Common equity 194,880 Total assets $ 290,000 Total liabilities and equity $ 290,000 The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industr- average, 2.5x, without affecting sales or net income. If inventories are sold and not replaced (thus reducing the current ratio to 2.5x), if the funds generated are used to reduce common equity (stock can be repurchased at book value), and if no other changes occur, by how much will the ROE change? Do not round intermediate calculations. Round your answer to two decimal places. ROE will -Select v by percentage points. What will be the firm's new quick ratio? Do not round intermediate calculations. Round your answer to two decimal places. x

Answer 1

Before any change is incorporated:

Current ratio =Current Assets / Current Liabilities

=196,910 / 46,980 = 4.191

ROE = Net income / Equity

= 7,000 / 194,880

= 0.0359

Now, the new owner is willing to change the inventory level to make the current ratio equivallent to 2.5 without making any change in any other component.

so new current assets will be 2.5*current liabilities. ie. 46,980* 2.5= 117,450

so, inventory level will be reduced by 196,910 - 117,450 = 79,460.

Further he wants the funds generated to be used for repayment of common stock.

So, Common stock will be repaid by 79,460.

New value of common stock after repayment will be 194,880 - 79,460 = 115,420

New ROE will be 7000 / 115,420 = 0.0606

Difference in ROE = 0.0606 - 0.0359 = 0.0247

Increase in Roe in % terms= $\frac{0.0247*100}{0.0359}$ = 68.80

ii) Quick ratio= $\frac{Quick Assets (Cash+Receivable)}{Current Liabilities}$

=$\frac{17400+49010}{46980}$

= 66410 / 46980 = 1.41

(There will be no change in quick ratio as change in Inventory or Equity won't affect Quick assets or Current Liabilities )