Question: The Hawley 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 currently being undertaken. Fixed assets total $1 million, and the firm finances 60 percent of its total assets with debt and the rest with equity (common stock). Hawley's interest cost currently is 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 (EBIT) at a rate of 12 percent on total sales.
a. What is the expected return on equity under each rent asset level? (Assume a 40 percent marginal 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?