Buchholz Corporation follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy.The firm's annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its tax rate is 25%.With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales.What is the difference in the projected ROEs between the restricted and relaxed policies?

Question

Quizplus · Accepted Answer

Under the restricted policy, current assets are 15% of sales, which is $60,000. Total assets = fixed assets + current assets = $100,000 + $60,000 = $160,000. Equity = 50% of total assets = $80,000. Net income = (EBIT - interest) * (1 - tax rate) = ($35,000 - $8,000) * 0.75 = $20,250. ROE = Net income / Equity = $20,250 / $80,000 = 25.31%. Under the relaxed policy, current assets are 25% of sales, which is $100,000. Total assets = $100,000 + $100,000 = $200,000. Equity = $100,000. ROE = $20,250 / $100,000 = 20.25%. Difference in ROE = 25.31% - 20.25% = 5.06%. The closest choice is 6.56%, which suggests a calculation error or rounding in the options.

Buchholz Corporation Follows a Moderate Current Asset Investment Policy, but It