Exhibit 21.1
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 40%. 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 Exhibit 21.1.If the firm adopts a restricted policy,how much lower would its interest expense be than under the relaxed policy?

Question

Quizplus · Accepted Answer

First, we need to calculate the firm's total assets for both the restricted and relaxed policy:

Restricted policy: 
Total assets turnover = 2.5
Fixed assets turnover = 4
Total assets = Sales / Total assets turnover = $3,600,000 / 2.5 = $1,440,000
Fixed assets = Total assets / Fixed assets turnover = $1,440,000 / 4 = $360,000
Current assets = Total assets - Fixed assets = $1,440,000 - $360,000 = $1,080,000

Relaxed policy:
Total assets turnover = 2.2
Fixed assets turnover = 4
Total assets = Sales / Total assets turnover = $3,600,000 / 2.2 = $1,636,363.64
Fixed assets = Total assets / Fixed assets turnover = $1,636,363.64 / 4 = $409,090.91
Current assets = Total assets - Fixed assets = $1,636,363.64 - $409,090.91 = $1,227,272.73

Next, we need to calculate the interest expense under each policy:

Restricted policy:
EBIT = $150,000
Interest expense = (Debt / Total assets) * Interest rate = (0.5 * $1,440,000) * 0.10 = $72,000

Relaxed policy:
EBIT = $150,000
Interest expense = (Debt / Total assets) * Interest rate = (0.5 * $1,636,363.64) * 0.10 = $81,818.18

Finally, we can calculate the difference in interest expense between the two policies:

$81,818.18 - $72,000 = $9,818.18 ≈ $9,818

Therefore, the answer is D) $9,818.

Exhibit 21.1 Hardwig Inc. Is Considering Whether to Pursue a Restricted or Restricted