Question

(16 pts) 9. Robinson Enterprises is considering whether to pursue an aggressive or conservative current asset investment policy. The firm's annual sales are $4,000,000; its fixed assets are $2,000,000; debt and equity are each 50% of total assets. EBIT is $400,000, the interest rate on the firm's debt is 10%, and the firm's tax rate is 30%. With an aggressive policy, current assets will be 20% of sales. Under a conservative policy, current assets will be 60% of sales. Show computations. Required: a) Determine the return on equity for the aggressive policy and the conservative policy. b) Explain which policy you would recommend.

Answer 1

Solution

a)	Return on Equity under each policy
	Particulars	Aggressive Policy	Conservative Policy
	Revenues (a)	$                   4,000,000	$                   4,000,000
	Current Assets (b)	$                      800,000	$                   2,400,000
		=20%*4000000	=60%*4000000
	Fixed Assets (c )	$                   2,000,000	$                   2,000,000
	Total Assets (d=b+c)	$                   2,800,000	$                   4,400,000
	Debt (e = 50% of d)	$                   1,400,000	$                   2,200,000
	Equity (f = 50% of d)	$                   1,400,000	$                   2,200,000
	EBIT	$                      400,000	$                       400,000
	Less: Interest (10% of e)	$                    (140,000)	$                    (220,000)
	EBT/Income	$                      260,000	$                       180,000
	Less: Tax @ 30%	$                      (78,000)	$                       (54,000)
	Profit after tax/ Earning for Shareholders (g)	$                      182,000	$                       126,000
	Equity (h)	$                   1,400,000	$                   2,200,000
	Return on Equity (g/h)	13.00%	5.73%

b)	Recommendation

We would recommend Agressive Policy as Reqturn on Equity is higher in agressve policy. This is due to the fact that under aggressive policy Debt and Equity are at lower level, while Revenue are same leading to lower ROE than conservative policy