Jarrett Enterprises is considering whether to pursue a restricted or relaxed current asset investment policy.The firm's annual sales are R400,000; its fixed assets are R100,000; debt and equity are each 50 percent of total assets.EBIT is R36,000, 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?

Question

Quizplus · Accepted Answer

First, we need to calculate the ROE for both policies:
- Restricted policy:
Current assets = 0.15 x R400,000 = R60,000
Fixed assets = R100,000
Total assets = R160,000
Debt = Equity = 0.5 x R160,000 = R80,000
EBIT = R36,000
Interest = 0.1 x R80,000 = R8,000
Taxable income = R28,000
Net income = (1-0.4) x R28,000 = R16,800
ROE = R16,800 / R80,000 = 21%
- Relaxed policy:
Current assets = 0.25 x R400,000 = R100,000
Fixed assets = R100,000
Total assets = R200,000
Debt = Equity = 0.5 x R200,000 = R100,000
EBIT = R36,000
Interest = 0.1 x R100,000 = R10,000
Taxable income = R26,000
Net income = (1-0.4) x R26,000 = R15,600
ROE = R15,600 / R100,000 = 15.6%
The difference in ROEs is 21% - 15.6% = 5.4%, which corresponds to choice C. Therefore, the best choice is:

Answer: C

Jarrett Enterprises Is Considering Whether to Pursue a Restricted or Relaxed