Problem:
Reynolds Equipment Company is investigating the use of various combinations of short-term and long-term debt in financing its assets. Assume that the company has decided to employ $30 million in current assets, along with $35 million in fixed assets, in its opera¬tions next year. Given this level of current assets, anticipated sales and EBIT for next year are $60 million and $6 million, respectively. The company's income tax rate is 40 percent. Stockholder? equity will be used to finance $40 million of its assets, with the remainder being financed by short-term and long-term debt. Reynolds is considering implementing one of the following financing policies:
|
|
Amount of
Short-Term Debt
|
Interest Rate
|
|
Financing Policy
|
(In Millions of Dollars)
|
LTD(%)
|
STD(%)
|
|
Aggressive (large amount of short-term debt)
|
$24
|
8.5
|
5.5
|
|
Moderate (moderate amount of short-term debt)
|
18
|
8.0
|
5.0
|
|
Conservative (small amount of short-term debt)
|
12
|
7.5
|
4.5
|
a. Determine the following for each of the financing policies:
i. Expected rate of return on stockholder? equity
ii. Net working capital position
iii. Current ratio
b. Evaluate the profitability versus risk trade-offs of these three policies.