### How would the overall risk of the firm vary under each policy?

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Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 40%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 12% of sales. Payne’s tax rate is 25%. Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 40%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 12% of sales. Payne’s tax rate is 25%. Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 40%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 12% of sales. Payne’s tax rate is 25%. |

part b

Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 40%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 12% of sales. Payne’s tax rate is 25%.

a. What is the expected return on equity under each current asset level?

Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 40%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 12% of sales. Payne’s tax rate is 25%.

b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? Why or why not?

Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 40%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 12% of sales. Payne’s tax rate is 25%.

c. How would the overall risk of the firm vary under each policy?

part a

Explanation

Sales last year = $ 1.6 million or 1600000

Projected Sales this year = 1,600,000*(1+ 25%)

= 2,000,000

EBIT = 2,000,000* 12%

= 240,000

Tax Rate = 25%

Fixed Asset = 1,000,000

1) Restricted policy in which current assets are 45% of projected sales

CA = 0.45* (2,000,000)

= 900,000

TA = FA + CA

= 1,000,000 + 900,000

= 1,900,000

Equity = Tax rate* (TA)

= 0.25* (1,900,000)

= 475,000

EBT = EBIT - Interest

= 240000 - 8%* (1900000*40%)

= 179200

Net Income = EBT(1 - t)

= 179200* (1 - 0.25)

= 134400

ROE = Net income/Equity

= 134400/475000

= 28.29%

2) Moderate policy in which current assets are 50% of projected sales

CA = 0.50* (2,000,000)

= 1000,000

TA = FA + CA

= 1,000,000 + 1000000

= 2000,000

Equity = Tax rate* (TA)

= 0.25* (2000,000)

= 500000

EBT = EBIT - Interest

= 240000 - 8%* (2000000*40%)

= 176000

Net Income = EBT(1 - t)

= 176000* (1 - 0.25)

= 132000

ROE = Net income/Equity

= 132000/500000

= 26.4%

3) Relaxed policy in which current assets are 60% of projected sales

CA = 0.60* (2,000,000)

= 1200,000

TA = FA + CA

= 1,000,000 + 1200000

= 2200,000

Equity = Tax rate* (TA)

= 0.25* (2200,000)

= 550000

EBT = EBIT - Interest

= 240000 - 8%* (2200000*40%)

= 169600

Net Income = EBT(1 - t)

= 169600* (1 - 0.25)

= 127200

ROE = Net income/Equity

= 127200/550000

= 23.13%

Answer

Expected return on equity;

1.) 28.29%

2.) 26.4%

3.) 23.13%