Scott Equipment Organization Is Trying to Determine

Scott Equipment Organization is trying to determine between short- and long-term debt for its operations next year. The company wants to examine three different scenarios to determine the rate of return on equity, the net working capital position and the current ratio that each of the options will deliver. The different scenarios are as follows.

Aggressive

$24 million STD

LTD 8.5%

Moderate

$18 million STD

LTD 8%

Conservative

$12 million STD

LTD 7.5%

This paper will analyze these different scenarios to determine the effect that each will have on the company's finances. The givens in the scenario are $30 million in current assets, $35 in long-term assets, $40 million in equity, sales of $60 million, EBIT of $6 million and a tax rate of 40%. The paper will not only analyze the three financial metrics but will examine the three scenarios in terms of the tradeoffs that they offer.

Return on Equity

For the three scenarios, the return on equity calculations are as follows:

Scenarios

Aggressive

Moderate

Conservative

STD $

STD %

0.96

0.72

0.48

Rate LTD

8.50%

8%

7.50%

Rate STD

5.50%

5%

4.50%

WA %

0.0562

0.0584

0.0606

Interest

1405000

1460000

1515000

EBIT-Int

4595000

4540000

4485000

Tax

1838000

1816000

1794000

Net Income

2757000

2724000

2691000

ROE

6.89%

6.81%

6.73%

These figures shows that there is little difference between the three scenarios with respect to ROE. Part of the reason is that while the more conservative scenarios have lower rates, they also have higher proportions of long-term interest, which comes at a higher rate. Thus, the two movements offset each other somewhat, and the net interest rate does not change too much between the scenarios. The conservative approach does deliver the lowest ROE, while the more aggressive approach delivers the higher ROE, but all three are within the same range.

Net Working Capital

The net working capital is the current assets less the current liabilities. There are significant differences in the current liabilities between the three scenarios, because the scenarios are based on changes to the short-term liabilities. The net working capital is therefore expected to be much higher in the conservative scenario because the ratio of short-term to long-term debt is going to be lower. The calculations work out as follows:

Net Working Capital Position

Aggressive

Moderate

Conservative

Current Assets

35

35

35

less

Current Liabilities

24

18

12

NWC ($Million)

11

17

23

The net working capital is higher under the conservative scenario. This is self-evident, because less of the debt is short-term in nature. By deferring debt, the company is improving the amount of working capital that it has today, which also serves to improve short-term liquidity.

Current Ratio

The current ratio is a measure of liquidity. It is basically reframing the net working capital, because the two figures used are the same. Thus, the current ratio is expected to be strongest under the conservative scenario because there is lower current liabilities under that scenario. Indeed, that is why it is the more conservative scenario. The numbers are:

Current Ratio

Aggressive

Moderate

Conservative

Current Assets

35

35

35

Current Liabilities

24

18

12

Current ratio

1.46

1.94

2.92

The current ratio is not bad under any scenario, though it is clearly better under the conservative scenario.

Tradeoffs

When making this decision, Scott is faced with a number of tradeoffs. The main tradeoff is short-term return vs. short-term liquidity. The conservative option sacrifices return for liquidity; the aggressive option sacrifices liquidity for return. Scott would, of course, make this decision based on its own comfort level with both of these things. There is no indication of what that comfort level might be.

However, it is worth considering two things. The first is that the difference with respect to the return on equity is not significant. The ROE would be much more greatly affected by the decision made on capital structure, than the decision about debt structure. There is a minor change in the ROE expected under the aggressive scenario, but the difference between 6.73% and 6.89% is not something you can sell your shareholders. In particular, other variables are likely to emerge that will affect the ROE much more than this one -- shareholders are going to wonder why a risky option was undertaken for such a small payoff.

The other factor that needs to be considered is that the liquidity is fine under any scenario. While the net working capital and the current ratio are quite different under each scenario, at no point even under the aggressive scenario does the company find itself in any sort of liquidity risk. The assumption is for a relatively small ROE. The company would ideally earn a higher ROE, as many firms do, but if even a small ROE delivers a comfortable working capital and liquidity position, then there is no reason for the company not to pursue the aggressive option. This view may, however, run up against the risk tolerance of management. When chasing $66,000 in net income on $60 million in sales, chasing such a miniscule difference in return while cutting the current ratio in half might easily be constrained by management's risk tolerance, or that of the shareholders. It would seem that the debt structure decision is going to be made largely with liquidity risk and working capital as the central bases, because those are the metrics most affected by the decision.