ABC Limited 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. Fixes assets total $1 million, and the firm plans to maintain a 60% debt-toassets ratio. ABC Limited’s weighted average interest rate is currently 8% on short- and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets 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 profits tax rate is 40%. (Assumption: debt = liabilities, debt-to-assets = total liabilities / total assets) a) What is the expected return on equity under each current assets level under policies (1), (2) and (3)? b) In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption? Why or why not?
ABC Limited 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. Fixes assets total $1 million, and the firm plans to maintain a 60% debt-toassets ratio. ABC Limited’s weighted average interest rate is currently 8% on short- and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets 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 profits tax rate is 40%. (Assumption: debt = liabilities, debt-to-assets = total liabilities / total assets)
a) What is the expected
b) In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption? Why or why not?
c) How would the firm’s risk be affected by the restrictive policy?
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