Scott Equipment Organization is investigating the use of various combinations of short-term and long-term debt in financing its assets. The organization has decided to employ $25 million in current assets, along with $40 million in fixed assets, in its operations next year. Anticipated sales and Earnings Before Interest and Taxes (EBIT) for next year are $60 million and $6 million, respectively. The organization’s income tax rate is 40%; stockholders’ equity will be used to finance $40 million of its assets, with the remainder being financed by short-term and long-term debt. Scott’s is considering implementing one of the following financing policies:
AMOUNT OF SHORT-TERM DEBT
FINANCIAL POLICY
IN MILLIONS
LTD
(%)
STD
(%)
Aggressive
(large amount of short-term debt)
$20
8.5
5.5
Moderate
(moderate amount of short-term debt)
$15
8.0
5.0
Conservative
(small amount of short-term debt)
$10
7.5
4.5
Based on the above information, the following calculations were determined.
BALANCE SHEET
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INCOME STATEMENT
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EXPECTED RATE OF RETURN ON STOCKHOLDERS’ EQUITY
ROE (RETURN ON COMMON EQUITY) = EAT (EARNINGS AFTER TAXES) / EQUITY
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AGGRESSIVE
Interest = ($20,000,000 x .055) + ($5,000,000 x .085) = $1,525,000
EBT = EBIT – interest = $6,000,000 – 1,525,000 = $4,475,000
Taxes = EBT x 40% = $4,475,000 x .40 = $1,790,000
EAT = EBT – taxes = $4,475,000 – 1,790,000 = $2,685,000
ROE = EAT / equity = $2,685,000 / 40,000,000 = 6.71%
MODERATE
Interest = ($15,000,000 x .05) + ($10,000,000 x .08) = $1,550,000
EBT = EBIT – interest = $6,000,000 – 1,550,000 = $4,450,000
Taxes = EBT x 40% = $4,450,000 x .40 = $1,780,000
EAT = EBT – taxes = $4,450,000 – 1,780,000 = $2,670,000
ROE = EAT / equity = $2,685,000 / 40,000,000 = 6.68%
CONSERVATIVE
Interest = ($10,000,000 x .045) + ($15,000,000 x .075) = $1,575,000
EBT = EBIT – interest = $6,000,000 – 1,575,000 = $4,425,000
Taxes = EBT x 40% = $4,425,000 x .40 = $1,770,000
EAT = EBT – taxes = $4,425,000 – 1,770,000 = $2,655,000
ROE = EAT / equity = $2,655,000 / 40,000,000 = 6.64%
NET WORKING CAPITAL POSITION
NWC = CURRENT ASSETS – CURRENT LIABILITIES
AGGRESSIVE
$25,000,000 – 20,000,000 = $5,000,000
MODERATE
$25,000,000 – 15,000,000 = $10,000,000
CONSERVATIVE
$25,000,000 – 10,000,000 = $15,000,000
CURRENT RATIO
CR = CURRENT ASSETS / CURRENT LIABILITIES
AGGRESSIVE
$25,000,000 / 20,000,000 = 1.25
MODERATE
$25,000,000 / 15,000,000 = 1.67
CONSERVATIVE
$25,000,000 / 10,000,000 = 2.50
EVALUATION
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SUMMARY
According to the calculations the aggressive financial policy will yield the highest profitability with $50,000 less interest deducted resulting in a $50,000 higher earnings before taxes. Although the aggressive policy will pay the most taxes, it will result in the highest return on equity at 6.71%, which is better for the owners. But the higher profitability brings with it greater risk. The net working capital is $10 million less than the conservative policy coupled with the lowest current ratio of 1.25 indicates the possibility that Scott Equipment Organization will be unable to pay its bills as they come due.
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Introduction Value Added Tax (VAT) was introduced in Nigeria in 1993 but became effective on 1 January 1994. VAT replaced the Sales Tax. VAT is governed by the Value Added Tax Act, Chapter V1, Laws of the Federation of Nigeria (LFN) 2004. The tax is administered by the Federal Inland Revenue Service (FIRS). Rates and scope Rates The standard VAT rate on goods and services is 5%. Value for VAT ...
The conservative financial policy has the lowest profitability and the lowest risk, but has the highest net working capital of $15 million and current ratio of 2.50. This indicates that the company is in a good position to pay its bills as they come due. The difference in the return on equity is small at 0.07%. The choice of which financial policy is best for Scott Equipment Organization is dependent on the risk preference of the decision maker.
References
Gitman, L. (2006).
Principles of managerial finance. (11th ed.).
New York, NY: Pearson, Addison Wesley.
