1. A company has $1,000,000 of fixed assets (or long-term assets) and requires its total debt to be 40% of its total assets. Two alternative working capital policies are as follows: alternative A calls for $800,000 of current assets and $100,000 of short-term debt, while alternative B calls for $400,000 of current assets and $500,000 of short-term debt. The interest rate on short-term debt is 8%, whereas the interest rate on long-term debt is 10%. The firm's tax rate is 30%. Earnings before interest and taxes are expected to be $400,000. Calculate the current ratio and the ROE for both alternatives A and B. Which of the two alternatives (A or B) will be selected by an aggressive financial manager?

To calculate the current ratio and return on equity (ROE) for alternatives A and B, we first need to understand the formulas for these ratios.

Current Ratio:
The current ratio is calculated by dividing current assets by current liabilities. It measures the ability of a company to pay its short-term obligations.

Current Ratio = Current Assets / Current Liabilities

Return on Equity (ROE):
The ROE is a financial ratio that measures the profitability of a company in relation to the shareholders' equity. It is calculated by dividing net income by shareholders' equity.

ROE = Net Income / Shareholders' Equity

Let's calculate the current ratio and ROE for each alternative:

Alternative A:
Total assets = Fixed Assets + Current Assets
Total liabilities = Short-term Debt
Shareholders' equity = Total assets - Total liabilities

Total assets = $1,000,000 (given)
Current Assets = $800,000 (given)
Fixed Assets = $1,000,000 (given)
Short-term Debt = $100,000 (given)
Total liabilities = $100,000 (short-term debt)
Shareholders' equity = $1,000,000 (total assets) - $100,000 (total liabilities) = $900,000

Current Ratio (A) = Current Assets / Current Liabilities
Current Ratio (A) = $800,000 / $100,000 = 8

Earnings before interest and taxes (EBIT) = $400,000 (given)
Net Income = EBIT - Interest Expense - Taxes
Interest Expense = Short-term Debt * Interest Rate = $100,000 * 8% = $8,000
Taxes = Net Income * Tax Rate = ($400,000 - $8,000) * 30% = $117,600
Net Income = $400,000 - $8,000 - $117,600 = $274,400

ROE (A) = Net Income / Shareholders' Equity
ROE (A) = $274,400 / $900,000 ≈ 30.49%

Alternative B:
Current Assets = $400,000 (given)
Short-term Debt = $500,000 (given)
Total liabilities = $500,000 (short-term debt)
Shareholders' equity = $1,000,000 (total assets) - $500,000 (total liabilities) = $500,000

Current Ratio (B) = Current Assets / Current Liabilities
Current Ratio (B) = $400,000 / $500,000 = 0.8

Interest Expense = Short-term Debt * Interest Rate = $500,000 * 8% = $40,000
Taxes = Net Income * Tax Rate = ($400,000 - $40,000) * 30% = $114,000
Net Income = $400,000 - $40,000 - $114,000 = $246,000

ROE (B) = Net Income / Shareholders' Equity
ROE (B) = $246,000 / $500,000 ≈ 49.2%

Now that we have calculated the current ratio and ROE for both alternatives A and B, we can compare them to determine which one will be selected by an aggressive financial manager.

The aggressive financial manager will prefer a higher ROE, as it indicates higher profitability and potential returns for the shareholders. In this case, alternative B has a higher ROE (around 49.2%) compared to alternative A (around 30.49%). Therefore, the aggressive financial manager will choose alternative B.