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The Rentz Corp. 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 presently being undertaken. Fixed assets total $1 million and the firm wishes to maintain a 60% debt ratio. Rentz's interest cost is currently 8% on both short term and longer term debt (both of which the firm uses in its permanent capital structure). Three alternatives regarding the projected current asset level are available to the firm: 1. a tight policy requiring current assets of only 45% of projected sales 2. Moderate policy of 50% of sales in current assets and 3. A relaxed policy requiring current assets of 60% sales. The firm expects to generate earnings before interest and taxes at a rate of 12% on total sales.
A. What is the expected return on equity under each current asset level
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?
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