Question

"The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 2.5×, without affecting sales or net income. If inventories are sold and not replaced (thus reducing the current ratio to 2.5×), if the funds generated are used to reduce common equity (stock can be repurchased at book value), and if no other changes occur, by how much will the ROE change? Do not round intermediate calculations. Round your answer to two decimal places."

Answer 1

Answer: ROE will increase by 5.54% if inventory is sold off

Step-by-step explanation:

Return on Equity before the inventories are sold of;

= Net Income/ Equity

= 15,000 / 200,000

= 7.5%

Inventories sold off

Inventories were sold off such that Current ratio is now 2.5 and the funds reduced equity, the inventory sold is;

Current ratio = Current Assets / Current Liabilities

2.5 = (Cash + Receivables + Inventories ) / (Accounts Payable + Other Current Liabilities)

2.5 = 10,000 + 50,000 + Inventories / 30,000 + 20,000

50,000 * 2.5 = 60,000 + Inventory

Inventory = $65,000

Inventory decreased by = 150,000 - 65,000

= $85,000

Equity therefore reduced by $85,000 as well to;

= 200,000 - 85,000

= $115,000

New Return on Equity = 15,000/115,000

= 13.04%

ROE will therefore change by;

= 13.04% - 7.5%

= 5.54%