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Nguyen Enterprises is considering two alternative working capital investment and financing policies. Policy A requires the firm to keep its current assets at 65 percent of forecasted sales and to finance 70 percent of its debt requirements with long-term debt (and 30 percent with short-term debt). Policy B, on the other hand, requires the firm to keep its current assets at 40 percent of forecasted sales and to finance 40 percent of its debt requirements with long-term debt (and 60 percent with short-term debt). Forecasted sales for next year are $20 million. Earnings before interest and taxes are projected to be 15 percent of sales. The firm's corporate income tax rate is 40 percent. Its fixed assets total $10 million. The firm desires to maintain its existing financial structure, which consists of 50 percent debt and 50 percent equity. Interest rates on short- and long-term debt are 12 and 15 percent, respectively.
a. Determine the expected rate of return on equity next year for Nguyen under each of the working capital policies.
b. Which policy is riskier? Cite specific evidence to support this contention.
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