Problem:
XYZ Company is trying to determine the optimal level of assets for the coming year. Sales are expected to increase to $2 million dollars. Fixed assets total $1 million, the firm wishes to maintain 60% debt ratio.
Interest cost is currently 8 Percent on short-term & long-term debt. 3 options are available to the firm. (1) a tight policy requiring current assets of only 45% of projected sales, (2) moderate policy of 50% of sales in current assets, (3) a relaxed policy requiring current assets of 60% of sales. The firm expects to generate earnings before interest and taxes at a rate of 12 % on total sales.
Q1. What is the expected return in equity under each current asset level? (assume 40% tax rate)
Q2. We have assumed that the level of expected sales is independent of current asset policy, Is this a valid assumption?
Q3. How would the overall riskiness of the firm vary under each policy?