Rentz Corporation is investigating the optimallevel of current assets for the coming year. Management expects sales to increase toapproximately $2 million as a result of an asset expansion presently being undertaken.Fixed assets total $1 million, and the firm plans to maintain a 60% debt-to-assets ratio.Rentz’s interest rate is currently 8% on both short- and long-term debt (which the firmuses in its permanent structure). Three alternatives regarding the projected currentassets level are under consideration: (1) a restricted policy where current assets wouldbe 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. Earningsbefore interest and taxes should be 12% of total sales, and the federal-plus-state taxrate is 40%.a. What is the expected return on equity under each current assets level?b. In this problem, we assume that expected sales are independent of the current assetsinvestment policy. Is this a valid assumption? Why or why not?c. How would the firm’s risk be affected by the different policies?
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 $1 million, and the firm plans to maintain a 60% debt-to-assets ratio.
Rentz’s interest rate is currently 8% on both 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 federal-plus-state tax
rate is 40%.
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 different policies?
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