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.
-Assume now the company expects that if it adopts a restricted policy, its sales will fall by 15 percent, EBIT will fall by 10 percent, but its total assets turnover, debt ratio, interest rate, and tax rate will remain the same. In this situation, 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

Under the restricted policy, sales fall by 15% to $3.06 million, and EBIT falls by 10% to $135,000. The total assets turnover is 2.5, so total assets are $1.224 million. Equity is 50% of total assets, so equity is $0.612 million. Interest is 10% of debt, which is $0.612 million, so interest is $61,200. Net income is EBIT minus interest, times (1 - tax rate), which is $44,280. ROE is net income divided by equity, which is 7.24%. Under the relaxed policy, sales are $3.6 million, EBIT is $150,000, total assets turnover is 2.2, so total assets are $1.636 million. Equity is $0.818 million, interest is $81,800, net income is $40,320, and ROE is 4.93%. The difference in ROEs is 7.24% - 4.93% = 2.31%, which is closest to 2.24%.

Callison Airlines Is Deciding Whether to Pursue a Restricted or Relaxed