Question

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.

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

a. $9,818
b. $8,861
c. $10,309
d. $9,327
e. $8,418

Answer 1

The interest expense under a restricted current asset investment policy would be $9,818 lower than under a relaxed policy. This is calculated by determining the total assets under each policy, calculating the corresponding debt, and then finding the interest expense based on the given interest rate.

Step-by-step explanation:

To determine how much lower the interest expense would be under a restricted current asset investment policy compared to a relaxed policy, we first need to calculate the total assets under each policy using the total assets turnover ratios provided. Total assets can be found using the formula:

Total Assets = Sales / Total Assets Turnover

Under the restricted policy, Total Assets = $3,600,000 / 2.5 = $1,440,000, and under the relaxed policy, Total Assets = $3,600,000 / 2.2 = $1,636,364.

Since the firm's debt is 50% of total assets, we can calculate the debt:

Debt (Restricted) = 50% of $1,440,000 = $720,000
Debt (Relaxed) = 50% of $1,636,364 = $818,182

Interest expense is the product of the interest rate and the amount of debt:

Interest Expense (Restricted) = 10% of $720,000 = $72,000
Interest Expense (Relaxed) = 10% of $818,182 = $81,818

The difference in interest expense is:

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

Therefore, the interest expense under a restricted policy would be $9,818 lower than under a relaxed policy.