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	%

3. 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?

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