The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 25×, without affecting sales or net income. If inventories are sold and not replaced (thus reducing the current ratio to 25×); if the funds generated are used to reduce common equity (stock can be repurchased at book value); and if no other changes occur, by how much will the ROE change? What will be the firm’s new quick ratio?
To identify: The change in return on equity and new quick ratio.
Quick Ratio: A part of liquidity ratios, quick ratio reflects the ability to oblige the short term debts of a company. It is calculated based on the liquid assets and current liabilities; a company has in an accounting period.
Return on Equity: Return on equity represents the amount earned as return by equity share holders; it can be calculated by dividing earnings available for equity share holders to total equity capital.
Explanation of Solution
Computation of return on equity
Items required for the calculation of return on equity are net income and common equity.
Given,
Net income is $15,000.
Common equity is $200,000.
Formula to calculate return on equity ratio,
Where,
- ROE is return on equity.
Substitute $15,000 for net income and $200,000 for common equity in the above formula,
Hence, the return on equity is 0.075 or 7.5%.
Compute the quick ratio
Given,
The current assets are $210,000.
The inventories are $150,000.
The current liabilities are $50,000.
Formula to compute quick ratio,
Substitute $210,000 for current assets, $150,000 for inventories and $50,000 for current liabilities in the above formula,
The quick ratio is 1.2 times.
In order to compute new quick ratio, old current ratio, new current assets and new return on equity need to calculate.
Computation of old current ratio
The items required for the calculation of current ratio are current liabilities and current assets.
Given,
Current assets are $210,000.
Current liabilities are $50,000.
Formula to calculate current ratio,
Substitute $210,000 for current assets and $50,000 for current liabilities in the above formula,
Hence, old current ratio is 4.2 times.
The new current ratio which is required to take is 2.5 times.
Compute the change in assets due to the current ratio as 2.5 times.
The current liabilities are $50,000. (Given)
The current ratio is 2.5 times.
Formula to calculate new current assets derives from the formula of current ratio,
Substitute $50,000 for current liabilities and 2.5 for current ratio in the above formula,
The new current assets are $125,000.
The difference between the currents assets refers the value of sold inventory.
Compute the sold inventory due to change in current assets
The current assets are $210,000. (Given)
The new current assets are $125,000. (Calculated)
Formula to calculate the sold inventory,
Substitute $210,000 for old current assets and $125,000 for new current assets in the above formula,
The value of inventor is curtailed by the $85,000.
Compute the balance inventory
The total inventory is $150,000. (Given)
The sold inventory is $85,000. (Calculated)
Formula to calculate the balance inventory,
Substitute $150,000 for inventory and $85,000 for sold inventory in the above formula,
The balanced inventory is $65,000.
Due to the sale the cash balance would also decrease by 65,000.
Computation of cash balance after the sale of inventory
Cash balance is $10,000.
The sale of inventory is $65,000.
Formula to calculate the new cash balance,
Substitute $10,000 for old balance and $65,000 for sold inventory in the above formula,
The cash balance after the sale of inventory is $55,000.
From the cash balance after sale of inventory, equity can be bought back. So the level of cash balance will reduce and equity will reduce by $65,000.
Compute the reduced equity:
The equity balance is $200,000. (Given)
The buyback equity share is $65,000. (Calculated)
Formula to calculate the reduced capital,
Substitute $200,000 for total equity shares and $65,000 for buyback shares in the above formula,
The reduced equity shares are $135,000.
Compute the new return on equity
The net income is $15,000. (Given)
The equity value is $135,000. (Calculated)
Formula to calculate the return on equity,
Where,
- ROE is return on equity.
Substitute $15,000 for net income and $135,000 for common equity in the above formula,
Hence, the return on equity is 0.1111 or 11.11%.
Compute the new quick ratio
The new current assets are $125,000.
The new inventories are $65,000.
The current liabilities are $50,000.
Formula to calculate quick ratio,
Substitute $125,000 for current assets, $65,000 for inventories and $50,000 for current liabilities in the above formula,
The new quick ratio is 1.2 times.
Quick ratio has remained same as there is no other current asset has changed except inventory and inventory is not the part of the terms used for the calculation of quick ratio.
Hence, the change in return on equity is 11.11% and there is no change in quick ratio and it is 1.2 times.
Want to see more full solutions like this?
Chapter 4 Solutions
Fundamentals of Financial Management, Concise Edition (MindTap Course List)
- You've collected the following information about Groot, Inc.: Profit margin Total asset turnover Total debt ratio Payout ratio = 4.44% = 3.50 = .25 = 29% a. What is the sustainable growth rate for the company? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What is the ROA? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) a. Sustainable growth rate b. ROA % 15.54 %arrow_forwardMicolash Industries plans to reduce the use of debt financing and increase the use of equity financing (for example, move from a 70% Debt-to-Capital Ratio to 50%). Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate (say 40%) all remain constant. Which of the following would occur? Group of answer choices The company’s interest expense would remain constant. The company would have less common equity than before. The company’s taxable income (EBT) would fall. The company would have to pay more taxes. The company’s net income would decrease.arrow_forwardNot use ai please don'tarrow_forward
- A firm wishes to maintain an internal growth rate of 6.4 percent and a dividend payout ratio of 25 percent. The current profit margin is 5.7 percent, and the firm uses no external financing sources. What must total asset turnover be? Internal growth rate 6.40% Payout ratio 25% Profit margin 5.70% Calculate Plowback ratio Return on assets Total asset turnoverarrow_forwardJC Goods, Inc. has a profit margin of 10% and a total assets turnover of 0.30. The president believes that the existing return on assets might be quadrupled and is dissatisfied with it. One way to do this is by raising the profit margin to 15%, and another is by raising the total assets turnover.What new asset turnover ratio is necessary to double the return on assets in addition to the 15% profit margin? a. 35%b. 45%c. 40%d. 50%arrow_forwardWACC and Optimal Capital Structure F. Pierce Products Inc. is considering changing its capital structure. F. Pierce currently has no debt and no preferred stock, but it would like to add some debt to take advantage of low interest rates and the tax shield. Its investment banker has indicated that the pre-tax cost of debt under various possible capital structures would be as follows: F. Pierce uses the CAPM to estimate its cost of common equity, rs and at the time of the analysis the risk-free rate is 5%, the market risk premium is 6%, and the companys tax rate is 40%. F. Pierce estimates that its beta now (which is unlevered because it currently has no debt) is 0.8. Based on this information, what is the firms optimal capital structure, and what would be the weighted average cost of capital at the optimal capital structure?arrow_forward
- Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year. Payne would like to determine the effect of various current assets policies on its financial performance. Payne has $1 million of fixed assets and intends to keep its debt ratio at its historical level of 60%. Payne’s debt interest rate is currently 8%. You are to evaluate three different current asset policies: (1) a restricted policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes are expected to be 12% of sales. Payne’s tax rate is 40%. What is the expected return on equity under each current asset level? In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? Why or why not? How would the overall risk of the firm vary under each policy?arrow_forwardLance Motors has current assets of $1.2 million. The company’s current ratio is 1.2, its quick ratio is 0.7, and its inventory turnover ratio is 4. The company would like to increase its inventory turnover ratio to the industry average, which is 5, without reducing its sales. Any reductions in inventory will be used to reduce the company’s current liabilities. What will be the company’s current ratio, assuming that it is successful in improving its inventory turnover ratio to 5?arrow_forwardplease see atteched filearrow_forward
- A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio? 1. b. Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. 2. d. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. 3. e. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash. 4. a. Use cash to increase inventory holdings. 5. c. Use cash to repurchase some of the company's own stock.arrow_forwardA firm wishes to maintain an internal growth rate of 10 percent and a dividend payout ratio of 44 percent. The current profit margin is 6.6 percent and the firm uses no external financing sources. What must total asset turnover be? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Total asset turnover timesarrow_forwardBob's Inc has the following balance sheet and income statement data see image... The new CFO thinks that inventory are excessive and could be lowered to cause the current ratio to equal industry average 3.00 w/o affecting either sales or net income. assuming that inventories are sold off and not replaced to get the current ratio to the target level and that the funds generated are used to buy back common stock at book value, by how much would the ROE change?arrow_forward
- Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage LearningEBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENT