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%

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?