Based on the following scenario, complete the calculations below:
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 $25 million in current assets, along with $40 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 (%)
(large amount of short-term debt) $20 8.5 5.5
(moderate amount of short-term debt) $15 8.0 5.0
(small amount of short-term debt) $10 7.5 4.5
Determine the following for each policy:
Expected rate of return on stockholders’ equity
Net working capital position
Evaluate profitability versus risk trade-offs of these policies. Would you rate them low, medium, or high with respect to profitability? Would you rate them low, medium, or high with respect to risk?
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