Question

Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2. Refer to the data for Hardwig, Inc. What's the difference in the projected ROEs under the restricted and relaxed policies

Answer 1

Answer:

1.88%

Explanation:

total annual sales = $3,600,000

EBIT = $150,000

net income = $150,000 x (1 - 25%) = $112,500

restricted policy:

asset turnover = 2.5

sales = $3,600,000

EBIT = $150,000

net income = $112,500

assets = $3,600,000 / 2.5 = $1,440,000

equity = $1,440,000 x 50% = $720,000

ROE = $112,500 / $720,000 = 15.63%

relaxed policy:

asset turnover = 2.2

sales = $3,600,000

EBIT = $150,000

net income = $112,500

assets = $3,600,000 / 2.2 = $1,636,364

equity = 50% x $1,636,364 = $818,182

ROE = $112,500 / $818,182 = 13.75%

difference between ROEs = 15.63% - 13.75% = 1.88%