Lahore School of Economics

Financial Management II
Working Capital Management – 1
Chapter 16 Assignment 11
Name: Syed Bilal Shujaat
ID: 18U00678
Sec: H

Q.1: 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 60% debt 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 assets level are
under consideration: (1) a tight 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 12% of total sales, and the federal-plus-state tax rate is 40%.
a) What is the expected return on equity under each current asset level?
b) In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption?
Why or why not?

 Tight policy ROE = $89,280/$760,000

=11.75%
 Moderate Policy ROE = $86,400/$800,000
=10.80%
 Relaxed ROE = $80,640/$880,000
=9.16%

1. Calgary Company is thinking of modifying its working capital assets policy. Fixed assets are $600,000, sales are
projected at $3 million, the EBIT/sales ratio is projected at 15%, the interest rate is 10% on all debt, the federal-plus
state tax rate is 40%, and Calgary plans to maintain a 50% debt-to-assets ratio. Three alternative current asset policies
are under consideration: 40%, 50%, and 60% of projected sales. What is the expected return on equity under each
alternative?
) Current Asset Policy of 40%

Sales= $3 million

Current Assets= 40%*$3 million= $1200000

Fixed Assets= $600,000

Debt/Assets= 0.50

Debt= 0.50*($1200000+600000)= $900,000

Since no current liabilities therefore we can calulate interest expense on total debt= 0.10*$900000= $90000

Earning before Interest and Tax= 15% of Sales= 0.15*3 million= $450,000

Interest expense= $90,000

Earnings before interest= $450,000-$90,000= $360,000

Federal tax rate= 40%

Earnings after Tax or Net Income= $360,000(1-0.40)= $216,000

Return on Equity= Net Income / Equity

Equity= Total Assets- Total Liabilities= ($1200000+$600000)-$900,000= $900,000

Return On equity= $216,000/$900,000= 0.24

b) Current Asset Policy of 50%

Sales= $3 million

Current Assets= 50%*$3 million= $1500000

Fixed Assets= $600,000

Debt/Assets= 0.50

Debt= 0.50*($1500000+600000)= $1050000

Since no current liabilities therefore we can calulate interest expense on total debt= 0.10*$1050000= $105000

Earning before Interest and Tax= 15% of Sales= 0.15*3 million= $450,000

Interest expense= $105,000

Earnings before interest= $450,000-$105,000= $345,000

Federal tax rate= 40%

Earnings after Tax or Net Income= $345,000(1-0.40)= $207,000

Return on Equity= Net Income / Equity

Equity= Total Assets- Total Liabilities= ($1500000+$600000)-$1050000= $1050000

Return On equity= $207,000/$1050000= 0.197

c) Current Asset Policy of 60%

Sales= $3 million

Current Assets= 60%*$3 million= $1800000

Fixed Assets= $600,000

Debt/Assets= 0.50

Debt= 0.50*($1800000+600000)= $1200000

Since no current liabilities therefore we can calulate interest expense on total debt= 0.10*$1200000= $120000

Earning before Interest and Tax= 15% of Sales= 0.15*3 million= $450,000

Interest expense= $120,000

Earnings before interest= $450,000-$120,000= $330,000

Federal tax rate= 40%

Earnings after Tax or Net Income= $330,000(1-0.40)= $198,000

Return on Equity= Net Income / Equity

Equity= Total Assets- Total Liabilities= ($1800000+$600000)-$1200000= $1200000

Return On equity= $198,000/$1200000= 0.165