WORKING CAPITAL POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 60% debt ratio. Rentz’s interest rate is currently 8% on both short-term and longer-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current asset level are under consideration: (1) a tight 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 12% of total sales, and the federal-plus-state tax rate is 40%. a. What is the expected return on equity under each current asset level? b. In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption? Why or why not? c. How would the firm’s risk be affected by the different policies?
WORKING CAPITAL POLICY Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately
$2 million as a result of an asset expansion presently being undertaken. Fixed assets total
$1 million, and the firm plans to maintain a 60% debt ratio. Rentz’s interest rate is currently 8% on both short-term and longer-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current asset level are under consideration: (1) a tight 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 12% of total sales, and the federal-plus-state tax rate is 40%.
a. What is the expected return on equity under each current asset level?
b. In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption? Why or why not?
c. How would the firm’s risk be affected by the different policies?
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