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.What's the difference in the projected ROEs under the restricted and relaxed policies?

Question

Quizplus · Accepted Answer

The difference in projected ROEs under the restricted and relaxed policies can be calculated by first determining the ROE under each policy. ROE is calculated as Net Income / Equity. 1. Calculate Total Assets using the Fixed Assets Turnover Ratio:    - Sales / Fixed Assets Turnover = Fixed Assets   - $3,600,000 / 4 = $900,000 in Fixed Assets2. Calculate Total Assets under each policy using the Total Assets Turnover:   - Restricted Policy: Sales / Total Assets Turnover = $3,600,000 / 2.5 = $1,440,000   - Relaxed Policy: Sales / Total Assets Turnover = $3,600,000 / 2.2 = $1,636,3643. Calculate Net Income:   - EBIT = $150,000   - Interest = Total Assets * 50% * 10% (since debt is 50% of total assets)   - Tax = (EBIT - Interest) * 40%   - Net Income = EBIT - Interest - TaxFor the Restricted Policy:   - Interest = $1,440,000 * 50% * 10% = $72,000   - Tax = ($150,000 - $72,000) * 40% = $31,200   - Net Income = $150,000 - $72,000 - $31,200 = $46,800For the Relaxed Policy:   - Interest = $1,636,364 * 50% * 10% = $81,818   - Tax = ($150,000 - $81,818) * 40% = $27,273   - Net Income = $150,000 - $81,818 - $27,273 = $40,9094. Calculate ROE:   - Equity = Total Assets * 50% (since equity is 50% of total assets)   - ROE = Net Income / EquityRestricted Policy ROE:   - Equity = $1,440,000 * 50% = $720,000   - ROE = $46,800 / $720,000 = 6.5%Relaxed Policy ROE:   - Equity = $1,636,364 * 50% = $818,182   - ROE = $40,909 / $818,182 = 5%Difference in ROE = 6.5% - 5% = 1.5%Therefore, the difference in the projected ROEs under the restricted and relaxed policies is 1.5%.

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