Hardwig Inc.
Hardwig Inc.is considering whether to pursue a restricted or relaxed current asset investment policy.The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets.EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%.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.
-Refer to the data for Hardwig, Inc.What's the difference in the projected ROEs under the restricted and relaxed policies?

Question

Quizplus · Accepted Answer

First, we need to calculate the projected ROE (return on equity) under both the restricted and relaxed policies.

Under the restricted policy:

ROE = [(EBIT - Interest) × (1 - Tax rate)] / Total equity
ROE = [($150,000 - $0.5 × $3,600,000 × 1/2 × 10%) × (1 - 0.25)] / ($1,800,000 × 1/2)
ROE = 8.33%

Under the relaxed policy:

ROE = [(EBIT - Interest) × (1 - Tax rate)] / Total equity
ROE = [($150,000 - $0.5 × $3,600,000 × 1/2 × 10%) × (1 - 0.25)] / ($1,800,000 × 1/2 × 2.2/2.5)
ROE = 10.21%

The difference in ROEs is:

10.21% - 8.33% = 1.88%

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

Hardwig Inc. Hardwig Inc.is Considering Whether to Pursue a Restricted or Relaxed