Working Capital Policy

Payne products sales last year were an anemic $1.6 million, but with an improved product mix it expects sales growth to be 25% this year, and Payne would like to determine the effect of various current asset policies on its financial performance. Payne has $1million 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 tight policy in which current assets are 45% of projected sales, (2) a moderate policy with 50% of sales tied up in current assets, (3) a relaxed policy requiring current assets of 60% of sales. Earnings before interest and taxes is 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 riskiness of the firm vary under each policy?