Muscarella Inc.has the following balance sheet and income statement data:The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average,2.70,without affecting either sales or net income.Assuming that inventories are sold off and not replaced to get the current ratio to the target level,and that the funds generated are used to buy back common stock at book value,by how much would the ROE change? $\begin{array}{|l|r|l|l|r|}
\hline \text { Cash } & \$ 14,000 & &\text { Accounts payable } & \$ 42,000 \
\hline \text { Receivables } & 70,000 & &\text { Other current liabilities } & 28,000 \
\hline \text { Inventories } & 210,000 & &\text { Total CL } & \$ 0,000 \
\hline \text { Total CA } & \$ 294,000 && \text { Long-term debt } & 70,000 \
\hline \text { Net fixed assets } & 126,000 && \text { Common equity } & 280,000 \
\hline \text { Total assets } & \$ 420,000 & &\text { Total liab. and equity } & \$ 420,000 \
\hline \text { Sales } & \$ 280,000 & & \
\hline \text { Net income } & \$ 21,000 & &\
\hline
\end{array}$

Question

Quizplus · Accepted Answer

First, we need to calculate the current ratio:
Current ratio = Total Current Assets / Total Current Liabilities
= $294,000 / $70,000
= 4.20
To bring the current ratio to the industry average of 2.70, we need to reduce inventories by:
Excess inventory = Current ratio - Industry average
= 4.20 - 2.70
= 1.50
Inventory reduction = Excess inventory * Total current liabilities
= 1.50 * $70,000
= $105,000
After selling off the excess inventory, the balance sheet would look like:
Cash = $14,000
Receivables = $70,000
Inventories = $105,000
Total current assets = $189,000
Fixed assets = $126,000
Total assets = $315,000
Accounts payable = $42,000
Other current liabilities = $28,000
Total current liabilities = $70,000
Long-term debt = $70,000
Common equity = $175,000 ($280,000 - $105,000)
Total liabilities and equity = $315,000
The current ratio would now be:
Current ratio = Total Current Assets / Total Current Liabilities
= $189,000 / $70,000
= 2.70
Now, we need to calculate the new return on equity (ROE) after the share buyback:
ROE = Net income / Common equity
= $21,000 / $175,000
= 0.12 or 12%
If the company buys back $105,000 worth of shares at book value, the common equity will decrease to $70,000. Therefore, the new ROE would be:
New ROE = Net income / Common equity
= $21,000 / $70,000
= 0.30 or 30%
The percentage change in ROE would be:
Percentage change in ROE = (New ROE - Old ROE) / Old ROE * 100%
= (30% - 12%) / 12% * 100%
= 150%
Therefore, the ROE would increase by 150%, which is equivalent to 4.50 times the original ROE. The closest answer choice is B, 4.50%.

Muscarella Inc A)428% B)4

Muscarella Inc A)428%
B)4