Callison Airlines is deciding whether to pursue a restricted or relaxed working capital investment policy. Callison's annual sales are expected to total $3.6 million, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50 percent of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10 percent, and the firm's tax rate is 40 percent. If the company follows a restricted policy, its total assets turnover will be 2.5.
Under a relaxed policy, its total assets turnover will be 2.2.
-What is the difference in the projected ROEs between the restricted and relaxed policies?
A) 2.24%
B) 1.50%
C) 1.00%
D) 0.50%
E) 0.33%

Question

Quizplus · Accepted Answer

To find the difference in projected ROEs, we need to first calculate the ROE under each policy.

Restricted policy:
Total assets = Sales / Total assets turnover = $3.6 million / 2.5 = $1.44 million
Current liabilities = 0.2 * $1.44 million = $288,000 (assuming current ratio of 1.2)
Working capital = Current assets - Current liabilities = $1.44 million - $288,000 = $1.152 million
Equity = Total assets - Debt = $1.44 million - 0.5 * $1.44 million = $720,000
EBIT = $150,000
Interest expense = 0.1 * 0.5 * $1.44 million = $72,000
Net income = (EBIT - Interest expense) * (1 - Tax rate) = ($150,000 - $72,000) * 0.6 = $46,800
ROE = Net income / Equity = $46,800 / $720,000 = 0.065 or 6.5%

Relaxed policy:
Total assets = Sales / Total assets turnover = $3.6 million / 2.2 = $1.636 million
Current liabilities = 0.2 * $1.636 million = $327,200 (assuming current ratio of 1.2)
Working capital = Current assets - Current liabilities = $1.636 million - $327,200 = $1.308 million
Equity = Total assets - Debt = $1.636 million - 0.5 * $1.636 million = $818,000
EBIT = $150,000
Interest expense = 0.1 * 0.5 * $1.636 million = $81,800
Net income = (EBIT - Interest expense) * (1 - Tax rate) = ($150,000 - $81,800) * 0.6 = $42,480
ROE = Net income / Equity = $42,480 / $818,000 = 0.052 or 5.2%

The difference in projected ROEs is: 6.5% - 5.2% = 1.3% or 0.013, which is closest to option B (1.50%).

Therefore, the best choice is B. Pursuing a restricted policy is expected to result in a higher ROE compared to a relaxed policy.

Callison Airlines Is Deciding Whether to Pursue a Restricted or Relaxed