SkyHigh Airlines is deciding whether to pursue a restricted or relaxed working capital investment policy. SkyHigh's annual sales are expected to total $3.6 million, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50 percent of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10 percent, and the firmâ??s tax rate is 40 percent. 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 and the ROE will be 5%.
Assume that SkyHigh expects that if it adopts a restricted policy, its sales will fall by 15 percent, EBIT will fall by 10 percent, but its total assets turnover, debt ratio, interest rate, and tax rate will remain the same. In this situation, what is the difference in the projected ROEs between the restricted and relaxed policies?
The solution explains how to calculate the ROE under Restricted / Relaxed Working Capital Investment policies