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...
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…
