Problem 16-13 Current Asset Us

Problem 16-13
Current Asset Usage Policy

Payne Products had $2.4 million in sales revenues in the most
recent year and expects sales growth to be 25% this year. Payne
would like to determine the effect of various current assets
policies on its financial performance. Payne has $3 million of
fixed assets and intends to keep its debt ratio at its historical
level of 60%. Payne’s debt interest rate is currently 9%. You are
to evaluate three different current asset policies: (1) a
restricted policy in which current assets are 45% of projected
sales, (2) a moderate policy with 50% of sales tied up in current
assets, and (3) a relaxed policy requiring current assets of 60% of
sales. Earnings before interest and taxes are expected to be 11% of
sales. Payne’s tax rate is 40%.

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

    Tight policy %
    Moderate policy %
    Relaxed policy %
  2. In this problem, we have assumed that the level of expected
    sales is independent of current asset policy. Is this a valid
    assumption?
    I.Sales are controlled only by the degree of
    marketing effort the firm uses, irrespective of the current asset
    policies it employs.
    II.The current asset policies followed by
    the firm mainly influence the level of long-term debt used by the
    firm.
    III.The current asset policies followed by
    the firm mainly influence the level of fixed assets.
    IV.No, this assumption would probably not be
    valid in a real world situation. A firm’s current asset policies
    may have a significant effect on sales.
    V.Yes, this assumption would probably be
    valid in a real world situation. A firm’s current asset policies
    have no significant effect on sales.
    -Select-IIIIIIIVVItem 4

    Why or why not?

  3. How would the overall risk of the firm vary under each
    policy?

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