Brakenridge Industries is considering the following two alternative working capital investment and financing policies:
Forecasted sales next year are $30 million. EBIT is projected at 25 percent of sales. Fixed assets are $30 million. The firm's income tax rate is 40 percent. Brakenridge desires to maintain its current capital structure, which consists of 50 percent debt and 50 percent equity. Interest rates on the company's short-term and long-term debt are 9 and 12 percent, respectively.
a. Determine the expected rate of return on equity capital under each of the working capital policies.
b. Which working capital policy is riskier?Explain.