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Working Capital Policy The Rentz Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm wishes to maintain a 60% debt ratio. Rentz’s interest cost is currently 8% on both short-term and longer-term debt (both of which the firm uses in its permanent capital structure). Three alternatives regarding the projected current asset level are available to the firm: (1) a tight policy requiring current assets of only 45% of projected sales, (2) a moderate policy of 50% of sales in current assets, and (3) a relaxed policy requiring current assets of 60% of sales. The firm expects to generate earnings before interest and taxes at a rate of 12% on total sales.

a. What is the expected return on equity under each current asset level? (Assume a 40% effective federal-plus-state tax rate.)

b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption?

c. How would the overall riskiness of the firm vary under each policy?