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?
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.