Problem:
Rentz Corporation is investigating 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 plans to maintain a 60% debt-toassets ratio.Rentz's interest rate is currently 8% on both short term and long term debt, (which the firm uses in its permanent structure) Three alternatives regarding the projected current assets level are under consideration (1) a restricted policy where current assets would only be 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 12% of total sales, and the federal-plus-state tax rate is 40%.
Required:
Question 1: What is the expected return on equity under each current assets level?
Question 2: In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption? Why or why not?
Question 3: How would the firm's risk be affected by the different policies?
Note: Please show how you came up with the solution.