Problem:
Payne products sales last year were an anemic $1.6 million, but with an improved product mix it expects sales growth to be 25% this year, and Payne would like to determine the effect of various current asset policies on its financial performance. Payne has $1million of fixed assets and intends to keep its tebt ratio at its historical level of 60%. Payne's debt interest rate is currently 8% You are to evaluate three different current asset policies: (1) a tight policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes is expected to be 12% of sales. Payne's tax rate is 40%.
Required:
Question 1: What is the expected return on equity under each current asset level?
Question 2: In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? Why or Why not?
Question 3: How would the overall riskiness of the firm vary under each policy?
Note: Please show how you came up with the solution.