Scott Equipment Organization is investigating the use of various combinations of short-term and long-term debt in financing its assets. Assume that the organization has decided to employ $30 million in current assets, along with $35 million in fixed assets, in its operations next year. Given the level of current assets, anticipated sales and Earnings Before Interest and Taxes (EBIT) for next year are $60 million and $6 million, respectively. The organization's income tax rate is 40%; Stockholders' equity will be used to finance $40 million of its assets, with the remainder being financed by short-term and long-term debt. Scott's is considering implementing one of the following financing policies:
Amount of Short-Term Debt
Financial Policy In mil. LTD % STD (%)
Aggressive (large amount of short-term debt) $24 8.5 5.5
Moderate (moderate amount of short-term debt $18 8.0 5.0
Conservative(small amount of short-term debt) $12 7.5 4.5
a. Determine the following for each of the financing policies:
1) Expected rate of return on stockholders' equity
2) Net working capital position
3) Current ratio
b. Evaluate the profitability versus risk trade-offs of these three policies. Would you rate each one "low", "medium", or "high" with respect to profitability? Would you rate each one "low", "medium", or "high" with respect to risk?
The solution explains the impact of different working capital policies on return on equity, working capital position and current ratio in an Excel attachment.