Response to the following problem:
The Rentz Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm wishes to maintain a 60 percent debt ratio. Rentz's interest cost is currently 8 percent on both short-term and longer-term debt (which the firm uses in its permanent structure).
Three alternatives regarding the projected current asset level are available to the firm:
(1) a tight policy requiring current assets of only 45 percent of projected sales,
(2) a moderate policy of 50 percent of sales in current assets, and
(3) a relaxed policy requiring current assets of 60 percent of sales. The firm expects to generate earnings before interest and taxes at a rate of 12 percent on total sales.
a. What is the expected return on equity under each current asset level? (Assume a 40 percent effective federal-plus-state tax rate.)
b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption?
c. How would the overall riskiness of the firm vary under each policy?