Callison Airlines Is Deciding Whether to Pursue a Restricted or Relaxed

question 49

Multiple Choice

Callison Airlines is deciding whether to pursue a restricted or relaxed working capital investment policy. Callison's annual sales are expected to total $3.6 million, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50 percent of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10 percent, and the firm's tax rate is 40 percent. If the company follows a restricted policy, its total assets turnover will be 2.5.
Under a relaxed policy, its total assets turnover will be 2.2.
-Assume now the company expects that if it adopts a restricted policy, its sales will fall by 15 percent, EBIT will fall by 10 percent, but its total assets turnover, debt ratio, interest rate, and tax rate will remain the same. In this situation, what is the difference in the projected ROEs between the restricted and relaxed policies?

• A) 2.24%
• B) 1.50%
• C) 1.00%
• D) 0.50%
• E) 0.33%

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Definitions:

Accounting

Process of measuring, interpreting, and communicating financial information to support internal and external business decision making.

Risk-Return Trade-Off

The principle that potential return rises with an increase in risk, describing the balance between the desire for the lowest possible risk and the highest possible returns.

Leverage

The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.