Cranberry Manufacturing Company is considering the following two alternative working capital investment and financing policies:
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Policy A
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Policy B
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Current assets --; Sales
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60%
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40%
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Short-term debt --; Total debt
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30%
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60%
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Forecasted sales next year are $150 million. EBIT is projected to be 20 percent of sales. The company's income tax rate is 40 percent. Fixed assets are $100 million.
Cranberry wishes to maintain its current capital structure, which consists of 60 percent debt and 40 percent equity. Interest rates on the company's short- term and long-term debt are 10 and 14 percent, respectively.
a. Determine the expected rate of return on equity under each of the working capital policies.
b. Which working capital policy is riskier? Explain.