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What is the expected return in equity under each current asset level?(assume 40% tax rate). We have assumed that the level of expected sales is independent of current asset policy, Is this a valid assumption?

XYZ Company is trying to determine the optimal level of assets for the coming year. Sales are expected to increase to $2 million dollars. Fixed assets total $1 million, the firm wishes to maintain 60% debt ratio.

Interest cost is currently 8 Percent on short-term & long-term debt. 3 options are available to the firm. (1) a tight policy requiring current assets of only 45% of projected sales, (2) moderate policy of 50% of sales in current assets, (3) a relaxed policy requiring current assets of 60% of sales. The firm expects to generate earnings before interest and taxes at a rate of 12 % on total sales.

What is the expected return in equity under each current asset level?(assume 40% tax rate)

We have assumed that the level of expected sales is independent of current asset policy, Is this a valid assumption?

How would the overall riskiness of the firm vary under each policy?

Solution Preview

** For the answer to the first question, please check the attached excel sheet as it has all the calculations. **

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2) No, this assumption would probably not be valid in a real world situation. A firm's current asset policies, particularly with regard to accounts receivable, such as discounts, collection period, and collection policy, may have a significant effect on sales. The exact nature of this function may be difficult to quantify, however, and determining an "optimal" current asset level may not be possible in actuality.

3) As the answers to question 1 indicate, the tighter policy leads to a ...

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