ROE Between Restricted and Relaxed Asset Investment Policy

ABC Enterprises follows a moderate current asset investment policy, but it is now considering whether to shift to a restricted or perhaps to a relaxed policy. The firm's annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its tax rate is 40%. With a restricted policy, current assets will be 10% of sales, while under a relaxed policy they will be 23% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies?

Solution Summary

This solution presents both the firm's income statement and balance sheet as it moves from a moderate to a restricted or relaxed current asset investment policy, and demonstrates the computation of its return on equity in each situation.