Current assets investment policy Rentz Corporation is investigating the optimal

Question

Current assets investment 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 $2 million, and the firm plans to maintain a 55% debt-to-assets ratio. Rentz's interest rate is currently 10% 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 restricted 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%.

What is the expected return on equity under each current asset level? Round your answers to two decimal places.

In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption?

Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.

No, this assumption would probably not be valid in a real world situation. A firm's current asset policies may have a significant effect on sales.

Yes, this assumption would probably be valid in a real world situation. A firm's current asset policies have no significant effect on sales.

Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.

Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.

Explanation / Answer

Rentz corporation Details Restricted Policy Moderate Policy Relaxed Policy Sales                 2,000,000                 2,000,000              2,000,000 Fixed Asset                 2,000,000                 2,000,000              2,000,000 Debt To assets 55% 55% 55% Current asset % of sales 45% 50% 60% Current Asset value                    900,000                 1,000,000              1,200,000 Total Asset                 2,900,000                 3,000,000              3,200,000 Debt Value                 1,595,000                 1,650,000              1,760,000 Equity Value                 1,305,000                 1,350,000              1,440,000 EBIT @12% of sales                    240,000                     240,000                  240,000 Less Interest @10%                    159,500                     165,000                  176,000 EBT                       80,500                       75,000                    64,000 Tax @40%                       32,200                       30,000                    25,600 Profit After Tax                       48,300                       45,000                    38,400 ROI 3.70% 3.33% 2.67% ROI % Restricted Policy 3.70% Moderate Policy 3.33% Relaxed Policy 2.67%

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