Howard is deciding if he should pursue a restricted or relaxed current asset investment policy

Howard is deciding if he should pursue a restricted or relaxed current asset investment policy. His annual sales are $200,000; its fixed assets are $50,000; debt and equity are each 50 percent of total assets. EBIT is $18,000, the interest rate on the firm's debt is 05 percent, and his company's tax rate is 20 percent. With a restricted policy, current assets will be 7.5 percent of sales. Under a relaxed policy, current assets will be 12.5 percent of sales. What is the difference in the projected ROEs between the restricted and relaxed policies?

Under restricted policy, current assets will be 7.5% of sales, therefore, the current assets will be equal to

$200,000 x 7.5% = $15,000

Then, you need to find out the total assets by adding current assets with fixed assets.

Total assets = current assets + fixed assets

Total assets = $15,000 + $50,000 = $65,000

As debt and equity are each 50 percent of total assets, then debt and equity are each equal to

$65,000 x 50% = $32,500

Then, we need to find the net income under the restricted policy as follows: -

EBIT (Earnings before interest and taxes) $18,000
Less: Interest expenses ($32,500 x 5%) 1,625
EBT (Earnings before taxes) $16,375
Less: Taxes (20% x $16,375) 3,275
Net Income $13,100

Then, we can find the ROE by using the following equation.

ROE = Net Income/Equity
= $13,100/$32,500
= 40.31%

Under relaxed policy, current assets will be 12.5% of sales, therefore, the current assets will be equal to

$200,000 x 12.5% = $25,000

Then, you need to find out the total assets by adding current assets with fixed assets.

Total assets = current assets + fixed assets

Total assets = $25,000 + $50,000 = $75,000

As debt and equity are each 50 percent of total assets, then debt and equity are each equal to

$75,000 x 50% = $37,500

Then, we need to find the net income under the restricted policy as follows: -

EBIT (Earnings before interest and taxes) $18,000
Less: Interest expenses ($37,500 x 5%) 1,875
EBT (Earnings before taxes) $16,125
Less: Taxes (20% x $16,125) 3,225
Net Income $12,900

Then, we can find the ROE by using the following equation.

ROE = Net Income/Equity
= $12,900/$37,500
= 34.40%

What is the difference in the projected ROEs between the restricted and relaxed policies?

40.31% - 34.40% = 5.91%

please see the attached file.