Zoe Ltd is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to $2 million as a result of an asset expansion that is currently being undertaken. Non current assets total $1 million, and the firm wishes to maintain a 60% debt ratio. Zoe's interest cost is currently 8% on both short term and long term debt (which the firm uses in its current structure). Three alternatives are available to the firm regarding the projected current asset level:

• A tight policy requiring current assets to be 45% of projected sales.
• A moderate policy of 50% of sales in current assets.
• A relaxed policy requiring 60% of sales.

The firm expects to generate earnings before interest and taxes at a rate of 12% on total sales.

Required

1. What is the expected return on equity under each current asset level? (Assuming a tax rate of 40%).
2. In this problem, we have assumed that the level of sales is independent of current asset policy. Is this a valid assumption?
3. How would the overall riskiness of the firm vary under each policy?