8.5 Warner Flooring Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately $1.2 million as a result of asset expansion presently being undertaken.

Fixed assets total $500,000, and the firm wishes to maintain a 60 percent debt ratio. Warner's inter est cost is curr ently 10 percent on both short-term debt and longer-term debt (which the firm uses in its permanent capital structure). Three alternatives regarding the projected current asset level are avail-

Order size 35 56 70 140 200 2800 Number of orders ____ ____ ____ ____ ____ ____ Average inventory ____ ____ ____ ____ ____ ____ Carrying cost ____ ____ ____ ____ ____ ____ Order cost ____ ____ ____ ____ ____ ____ Total cost able to the firm: (1) an aggressive policy requiring current assets of only 45 percent of projected sales, (2) an average policy of 50 percent of sales in current assets, and (3) a conservative policy requiring current assets of 60 percent of sales. The firm expects to generate earnings before interest and taxes at a rate of 12 percent on total sales.
A. What is the expected return on equity under each current asset level? (Assume a 40 percent tax rate.)
B. In this problem, we have assumed that the earnings rate and the level of expected sales are independent of current asset policy. Is this a valid assumption?
C. How would the overall riskiness of the firm vary under each policy? Discuss specifically the effect of current asset management on demand, expenses, fixed-charge coverage, risk of insolvency, and so on.