Question

Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 40% debt-to-assets ratio. Rentz's interest rate is currently 8% on both short-term and longer-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current asset level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 14% of total sales, and the federal-plus-state tax rate is 40%.

What is the expected return on equity under each current asset level? Round your answers to two decimal places.

Answer 1

To find the expected return on equity for Rentz Corporation under each current asset level policy, calculations are made based on projected sales, the debt-to-assets ratio, interest rates, and tax rates. These calculations include EBIT, interest expense, net income, total equity, and finally the ROE for each policy.

Step-by-step explanation:

To calculate the expected return on equity (ROE) for Rentz Corporation under each of the current asset levels, we will follow these steps:

1. Calculate total projected sales
2. Estimate the earnings before interest and taxes (EBIT)
3. Determine the projected current assets
4. Calculate total assets
5. Figure out the total amount of debt using the debt-to-assets ratio
6. Compute the interest expense
7. Determine the earnings before taxes (EBT)
8. Calculate taxes
9. Find the net income
10. Derive the total equity
11. Calculate ROE under each policy

Let's use projected sales of $2 million:

• Total Sales = $2 million
• EBIT = 14% of Total Sales = 0.14 × $2 million = $280,000
• Total Fixed Assets = $1 million
• Debt-to-Assets Ratio = 40%
• Tax Rate = 40%
• Interest Rate = 8%

Next, let's calculate for each policy:

Restricted Policy (45% of Sales)

• Projected Current Assets = 45% × $2 million = $900,000
• Total Assets = Projected Current Assets + Fixed Assets = $900,000 + $1 million = $1.9 million
• Total Debt = Debt-to-Assets Ratio × Total Assets = 0.40 × $1.9 million = $760,000
• Interest Expense = Interest Rate × Total Debt = 0.08 × $760,000 = $60,800
• EBT = EBIT - Interest Expense = $280,000 - $60,800 = $219,200
• Taxes = Tax Rate × EBT = 0.40 × $219,200 = $87,680
• Net Income = EBT - Taxes = $219,200 - $87,680 = $131,520
• Total Equity = Total Assets - Total Debt = $1.9 million - $760,000 = $1.14 million
• ROE = Net Income / Total Equity = $131,520 / $1.14 million = 11.54%

Moderate Policy (50% of Sales)

Repeat the process with current assets at 50% of sales

Relaxed Policy (60% of Sales)

Repeat the process with current assets at 60% of sales