Rentz Corporation is investigating 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 plans to maintain a 60% debt ratio. Rentzs interest rate is currently 8% on both short-term and longer-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a tight policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assetswouldbe60%ofsales. Earningsbefore interestandtaxesshouldbe12%of total sales, and the federal-plus-state tax rate is 40%.

a. What is the expected return on equity under each current asset level?

b. In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption? Why or why not?

c. How would the firms risk be affected by the different policies

(10 Marks)