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ROE Between Restricted and Relaxed Asset Investment Policy

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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?

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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.

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Under a restricted policy, the firm's Balance Sheet looks like this:

Current Assets $ 40,000 (10% of Sales of $400,000)
Fixed Assets 100,000 (Given)
Total Assets $140,000
Total Liabilities ( 70,000) (50% of Total Assets, since Assets=Liabilities+Equity)
Total Equity $ 70,000 (The remaining 50% of Total Assets)

Its Income Statement will look like this:

EBIT ...

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