Edwards Enterprises follows a moderate current asset investment policy, but it i

Question

Edwards Enterprises follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy. The firm's annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its tax rate is 40%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies?

Explanation / Answer

Hi, Please find the calculations below: 15% of Sales 60000 (Current Assets) + 100000 (Fixed Assets) = 160000 50% Debt = 80000 50% Equity = 80000 Total liability and equity = 160000 EBIT = 35000 - Interest = 8000 EBT = 27000 -Taxes = 10800 Net Income = 16200 25% of Sales 100000 (Current Assets) + 100000 (Fixed Assets) = 200000 50% Debt = 100000 50% Equity = 100000 Total liability and equity = 200000 EBIT = 35000 - Interest = 10000 EBT = 25000 -Taxes = 10000 Net Income = 15000 ROE = Net Income/Equity = 16200/80000 = 20.25 % (Under 15% Sales) ROE = Net Income/Equity = 15000/100000 = 15% % (Under 25% Sales) Difference in Return on Equities = 20.25% - 15% = 5.25% Thanks, Aman

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