Question

4. The Hawley Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of asset expansion presently been undertaken. Fixed assets total $1 million, and the firm finances 60% of its total assets with debt and the rest with equity. Hawley's interest cost currently is 8% on both short term and longer term debt. Three alternatives regarding the projected current asset level are available to the firm: (1) A tight policy requiring current assets of only 45% of projected sales, (2) a moderate policy of 50% of sales as current asset level, and (3) a relaxed policy requiring current assets of 60% of sales. The firm expects to generate EBIT equal to 12% of sales. a. What is the expected return on equity under each current asset level? (Assume 40% corporate tax rate) b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? Explain. c. How would the overall riskiness of the firm vary under each policy?

Answer 1

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C w ENG 05:33 18-06-2020 26 25 Х AX276 . AW AX AY AZ BA BB BC BD BE BE BG BH BI BJ BK 253 SALES 2000000 100% TOTAL ASSETS CURRENT ASSETS FIXED ASSETS 1000000 60% DEBT 1140000 40% EQUITY 760000 RESTRICTED POLICY 900000 + 1900000 254 255 256 257 258 259 260 261 262 45% OF SALES MODERATE POLICY 1000000 + 1000000 2000000 1200000 800000 50% OF SALES RELAXED POLICY + 1000000 11 2200000 1320000 880000 1200000 60% OF SALES 263 EBIT % of sales = 12% rate of interest = 8% 264 265 240000 RESTRICTED RELAXED MODERATE 240000 EBIT 240000 INTEREST 91200 148800 266 267 268 269 270 271 272 273 274 275 b 276 96000 144000 57600 240000 105600 (8% ON DEBT) 134400 53760 59520 EBT TAX (40%) NET INCOME RETURN ON EQUITY 89280 86400 80640 9.16% 11.75% 10.80% [NET INCOME/EQUITY] NO, THIS ASSUMPTION WOULD PROBABLY NOT VALID AS CURRENT ASSET POLICIES DO HAVE SIGNIFICANT EFFECT ON SALES Sheet1 Sheet2 Z SCORE insu pv fv cash opti LINE OF CREDIT Sheet5 eoq miller CARD BANKER ACCEPTANC FACTOR SI DISC FOCA ... +

C w ENG 05:33 18-06-2020 26 25 Х AW292 . AW AX AY AZ BA BB BC BD BE BE BG BH BI BJ BK 277 C 278 279 280 281 282 EACH POLICY HAS ITS ADVANTAGES & DISADVANTAGES RESTRICTED POLICY WILL REDUCE SALES BUT WILL ALSO REDUCE BAD DEBT AND OTHER COLLECTION EXPENSES AND SO RISK RELAXED POLICY WILL INCREASE SALES BUT WILL ALSO INCREASE BAD DEBT AND COLLECTION COSTS AND SO RISK INCREASES MODERATE POLICY IS LARGELY FOLLOWED BY MAJOR COMPANIES AS THEY FOLLOW HOW MARKET BEHAVES SO RISK IS MODERATE HERE BUT IT STILL DEPENDS ON HOW COMPANY IS ABLE TO TACKLE THE SITUATION 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 PAN Sheet1 Sheet2 Z SCORE insu pv fv cash opti LINE OF CREDIT Sheet5 eoq miller CARD BANKER ACCEPTANC FACTOR SI DISC FOCA ... + ..