Question 1: 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 $30 million in current assets, along with $35 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 (%)
|
|
Aggressive
(large amount of short-term debt)
|
$24
|
8.5
|
5.5
|
|
Moderate
(moderate amount of short-term debt)
|
$18
|
8.0
|
5.0
|
|
Conservative
(small amount of short-term debt)
|
$12
|
7.5
|
4.5
|
a. Determine the following for each of the financing policies:
1) Expected rate of return on stockholders’ equity
2) Net working capital position
3) Current ratio
b. Evaluate the profitability versus risk trade-offs of these three policies. Would you rate each one “low”, “medium”, or “high” with respect to profitability? Would you rate each one “low”, “medium”, or “high” with respect to risk?
Question 2: Relaxation of credit standards: Lewis Enterprises is considering relaxing its credit standards to increase its currently sagging sales. As a result of the proposed relaxation, sales are expected to increase by 10% from 10,000 to 11,000 units during the coming year; the average collection period is expected to increase from 45 to 60 days; and bad debts are expected to increase from 1% to 3% of sales. The sale price per unit is $40, and the variable cost per unit is $31. The firm’s required return on equal-risk investments is 25%. Evaluate the proposed relaxation, and make a recommendation to the firm. (Note: Assume a 365-day year.)
Question 3: ETHICS PROBLEM: Controlled disbursing is defined as an information product—that is, the bank on which the company’s checks are drawn provides an early-morning notification of the total dollar amount of checks that will clear the account that day. Based on that notification, the company may then fund the account for that amount by the close of business that afternoon. How might controlled disbursing still be viewed as a form of “remote disbursing,” and therefore be considered unethical?
Question 4: Effective annual rate: A financial institution made a $10,000, 1-year discount loan at 10% interest, requiring a compensating balance equal to 20% of the face value of the loan. Determine the effective annual rate associated with this loan. (Note: Assume that the firm currently maintains $0 on deposit in the financial institution.)