Question

Hardwig Inc.
Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

Refer to the data for Hardwig, Inc. Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same. In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies?

a. 2.46%

b. 3.27%

c. 2.24%

d. 2.98%

e. 2.70%

Answer 1

	Restricted	Relaxed
Sales	3060000	3600000
Total Assets	1224000	1636363.636
Debt	612000	818181.8182
Equity	612000	818181.8182
EBIT	135000	150000
Less: Interest	61200	81818.18182
EBT	73800	68181.81818
Less: Tax	29520	27272.72727
Net Income	44280	40909.09091
ROE	7.24%	5.00%
Difference	2.24%
Hence, the answer is c.

1 A B С Restricted Relaxed 2 Sales =3600000*85% =3600000 3 Total Assets =B2/2.5 =C2/2.2 4 Debt =B3*50% =C3*50% 5 Equity =B3-B4 =C3-C4 6 EBIT =150000*90% =150000 7 Less: Interest =B4*10% =C4*10% 8 EBT =B6-B7 =C6-C7 9 Less: Tax =B8*40% =C8*40% 10 Net Income =B8-B9 =C8-C9 11 ROE =B10/B5 =C10/C5 12 Difference =B11-C11 13 14 Hence, the answer is c. 15