Simmons Industries Is Considering Two Alternative Working Capital Investment and Financing

question 63

Multiple Choice

Simmons Industries is considering two alternative working capital investment and financing policies. Policy A requires the firm to keep its current assets at 60% of forecasted sales and to finance 75% of its debt requirements with long-term debt (and 25% with short-term debt) . Policy B, on the other hand, requires the firm to keep current assets at 40% of forecasted sales and to finance 50% of its debt requirements with long-term debt (and 50% with short-term debt) . Forecasted sales for next year are $20 million. Earnings before interest and taxes are projected to be 20% of sales. The firm's corporate income tax rate is 40%. Its fixed assets total $10 million. The firm desires to maintain its existing capital structure that consists of 50% debt (both long-term and short-term) and 50% equity. Interest rates on short- and long-term debt are 8% and 10%, respectively. ​
Determine the expected rate of return on equity next year for Simmons Industries under each of the working capital policies.

• A) 26.9%; 30.4%
• B) 21%; 26.7%
• C) 8.1%; 9.1%
• D) 16.1%; 21.3%

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Definitions:

Operating Activities

Activities that relate to the primary operations of the company, including cash flows from selling goods and services.

Indirect Method

A way of presenting the cash flow statement where net income is adjusted for changes in balance sheet items to calculate cash flow from operating activities.

Net Income

Represents a company's earnings after all expenses, charges, and taxes have been subtracted from total revenue, reflecting the financial health of the company.

Operations

Refers to the day-to-day activities necessary for a business to function, encompassing production, sales, and distribution.