Jarrett Enterprises is considering whether to pursue a restricted or relaxed current asset investment policy.The firm's annual sales are $400,000; its fixed assets are $100,000; debt and equity are each 50 percent of total assets.EBIT is $36,000, the interest rate on the firm's debt is 10 percent, and the firm's tax rate is 40 percent.With a restricted policy, current assets will be 15 percent of sales.Under a relaxed policy, current assets will be 25 percent of sales.What is the difference in the projected ROEs between the restricted and relaxed policies?
A)0%; the ROE's are equal.
B)6.2%
C)5.4%
D)1.6%
E)3.8%

Question

Quizplus · Accepted Answer

First, we need to calculate the currently projected ROE:

ROE = (EBIT - Interest Expense) x (1 - Tax Rate) / Total Assets
ROE = ($36,000 - $5,000) x (1 - 0.4) / $200,000
ROE = 12%

Restricted Policy:
Current assets will be 15% of sales, which is $60,000. This means that the rest of the assets are fixed assets of $100,000 and total assets are $160,000.

ROE = ($36,000 - ($160,000 x 10%)) x (1 - 0.4) / $160,000
ROE = 10.6%

Relaxed Policy:
Current assets will be 25% of sales, which is $100,000. This means that the rest of the assets are fixed assets of $100,000 and total assets are $200,000.

ROE = ($36,000 - ($200,000 x 10%)) x (1 - 0.4) / $200,000
ROE = 16%

The difference in the projected ROEs between the restricted and relaxed policies is:
16% - 10.6% = 5.4%

Therefore, the best choice is C, to pursue a relaxed current asset investment policy, as it would result in a higher projected ROE.

Jarrett Enterprises Is Considering Whether to Pursue a Restricted or Relaxed