A corporation is attempting to manage more effectively its working capital. They are looking at two possible policies:
Policy A: Current assets would be 40 percent of projected sales of $5,000,000 and current debt would be $1,500,000.
Policy B: Current assets would be 50 percent of projected sales of $5,000,000 and current debt would be $1,500,000.
Fixed assets are $4,000,000, and the firm plans to maintain a 60 percent debt-to-assets ratio. The interest rate on short-term debt is 6 percent and the interest rate on long-term debt is 9 percent. The earnings before interest and taxes are expected to be $900,000. The corporation has a tax rate of 40 percent.
a) Determine the return on equity for each alternative
b) Explain which policy is more risky
c) Recommend which policy should be chosen