Payne Products had $1.6 million in sales revenues in the most recent year and expects sales growth to be 25% this year.

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Payne Products had $1.6 million in sales revenues in the most
recent year and expects sales growth to be 25% this year. Payne
would like to determine the effect of various current assets
policies on its financial performance. Payne has $1 million of
fixed assets and intends to keep its debt ratio at its historical
level of 60%. Payne’s debt interest rate is currently 8%. You are
to evaluate three different current asset policies: (1) a
restricted policy in which current assets are 45% of projected
sales, (2) a moderate policy with 50% of sales tied up in current
assets, and (3) a relaxed policy requiring current assets of 60% of
sales. Earnings before interest and taxes are expected to be 12% of
sales. Payne’s tax rate is 40%. 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? Why or why not? c. How
would the overall risk of the firm vary under each policy?