The Hawley Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion currently being undertaken. Fixed assets total $1 million, and the firm finances 60 percent of its total assets with debt and the rest with equity (common stock). Hawley’s interest cost currently is 8 percent on both short-term and longer-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current asset level are available to the firm: (1) a tight policy requiring current assets of only 45 percent of projected sales, (2) a moderate policy of 50 percent of sales in current assets, and (3) a relaxed policy requiring current assets of 60 percent of sales. The firm expects to generate earnings before interest and taxes (EBIT) at a rate of 12 percent on total sales.
a. What is the expected return on equity under each current asset level? (Assume a 40 percent marginal tax rate.)
b. In this problem we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption?
c. How would the overall riskiness of the firm vary under each policy?
b. No, the assumption that the expected level of sales is independent of current asset policy is not valid. 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. Changing in level of debt and maintaining the level of current assets (below, equal or above fixed assets) can vary the overall riskiness of the any firm.