Shahrokhi Enterprises follows a moderate current asset investment policy,but it is now considering whether to shift to a restricted or perhaps 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 40%.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?
A)4.3%
B)4.7%
C)5.3%
D)5.8%

Question

Quizplus · Accepted Answer

First, we need to find out the current assets, current liabilities, and net operating income (EBIT) under both restricted and relaxed policies.

Restricted Policy:
Current assets = 15% * $400,000 = $60,000
Current liabilities = ?
Let's assume that accounts payable will be the only current liability.
Since the firm follows a moderate current asset investment policy, we can assume that current liabilities will be equal to current assets.
So, current liabilities = $60,000
Net operating income (EBIT) = $35,000

Relaxed Policy:
Current assets = 25% * $400,000 = $100,000
Current liabilities = ?
Again, we can assume that current liabilities will be equal to current assets.
So, current liabilities = $100,000
Net operating income (EBIT) = $35,000

Next, we need to find out the net income and return on equity (ROE) under both policies.

Net Income:
Under both policies, the interest expense will be the same.
Interest expense = 10% * $50,000 (total debt) = $5,000
Taxable income = EBIT - Interest expense = $35,000 - $5,000 = $30,000
Net income = Taxable income - Taxes = $30,000 - 0.4($30,000) = $18,000

ROE:
ROE = Net income / Total equity
Total equity = Total assets - Total debt
Under both policies, total assets will be the same.
Total assets = $100,000 (fixed assets) + Current assets
Restricted policy: Total assets = $100,000 + $60,000 = $160,000
Relaxed policy: Total assets = $100,000 + $100,000 = $200,000
Total debt will also be the same for both policies.
Total debt = 50% * Total assets = 0.5 * ($160,000 or $200,000) = $80,000
Total equity (restricted policy) = $160,000 - $80,000 = $80,000
Total equity (relaxed policy) = $200,000 - $80,000 = $120,000

ROE (restricted policy) = $18,000 / $80,000 = 0.225 or 22.5%
ROE (relaxed policy) = $18,000 / $120,000 = 0.15 or 15%

Difference in ROE = ROE (restricted policy) - ROE (relaxed policy)
Difference in ROE = 0.225 - 0.15 = 0.075 or 7.5%
Therefore, the difference in the projected ROEs between the restricted and relaxed policies is 7.5%, or 5.3% (rounded to one decimal place). The best choice is C.

Shahrokhi Enterprises Follows a Moderate Current Asset Investment Policy,but It