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 ratio. Rentz's interest rate is currently 8% 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 tight 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 return on equity under each current asset level? b. In this problem, we assume that expected sales are independent of the current asset 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 ratio. Rentz's interest rate is currently 8% 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 tight 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 return on equity under each current asset level? b. In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption? Why or why not? c. How would the firm's risk be affected by the different policies?

EBK CONTEMPORARY FINANCIAL MANAGEMENT

14th Edition

ISBN:9781337514835

Author:MOYER

Publisher:MOYER

Chapter16: Working Capital Policy And Short-term Financing

Section: Chapter Questions

Problem 4P

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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 ratio. Rentz's interest
rate is currently 8% 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 tight
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 return on equity under each
current asset level?
b. In this problem, we assume that expected sales are
independent of the current asset 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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