Answers and Solutions:22 - 922-13 a. Return on equity may be computed as follows: Tight Moderate Relaxed Current assets (% of sales ×Sales) $ 900,000 $1,000,000 $1,200,000 Fixed assets 1,000,0001,000,0001,000,000Total assets $1,900,000$2,000,000$2,200,000Debt (60% of assets) $1,140,000 $1,200,000 $1,320,000 Equity 760,000800,000880,000Total liab./equity $1,900,000$2,000,000$2,200,000EBIT (12% ×$2 million) $ 240,000 $ 240,000 $ 240,000 Interest (8%) 91,20096,000105,600Earnings before taxes $ 148,800 $ 144,000 $ 134,400 Taxes (40%) 59,52057,60053,760Net income $ 89,280$ 86,400$ 80,640Return on equity 11.75% 10.80% 9.16% b. 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. c. As the answers to Part a indicate, the tighter policy leads to a higher expected return.
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