Chapter 16 Problem 4 from Contemporary Financial ...



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Chapter 16 Problem 4 from Contemporary Financial Management 11e, Moyer. Wilson Electric Company, a manufacturer of various types of electrical equipment, is examining its working capital investment policy for next year. Projected fi xed assets and current liabilities are $20 million and $18 million, respectively. Sales and EBIT are partially a function of the company’s investment in working capital—particularly its investment in inventories and receivables. Wilson is considering the following three different working capital investment policies: Working Capital Investment Policy Investment in Current Assets (in Millions of Dollars) Projected Sales (in Millions of Dollars) EBIT (in Millions of Dollars) Aggressive (small investment in current assets) Moderate (moderate investment in current assets) Conservative (large investment in current assets) $28 30 32 $59 60 61 $5.9 6.0 6.1 a. Determine the following for each of the working capital investment policies: i. Rate of return on total assets (that is, EBIT/total assets) ii. Net working capital position iii. Current ratio b. Describe the profi tability versus risk trade-off s of these three policies.

a.

Alternative Working Capital

Investment Policies

(millions of dollars)

Aggressive Moderate Conservative

Current Assets (C/A) $28 $30 $32

Fixed Assets (F/A) 20 20 20

Total Assets (T/A) $48 $50 $52

Current Liab. (C/L) $18 $18 $18

Forecasted Sales $59 $60 $61

Expected EBIT $5.9 $6.0 $6.1

(i) Rate of Return on

Total Assets 12.29% 12.0% 11.73%

(ii) Net Working Cap.

Position $10 $12 $14

(iii) Current Ratio 1.56 1.67 1.78

b. Expected profitability (rate of return on total assets) and risk (as measured by net working capital position or current ratio) are lowest under the conservative policy and highest under the aggressive policy. In other words, the firm that desires to increase its expected returns through reduced investment in working capital subjects itself to a higher risk of incurring financial difficulties.

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