Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.-Refer to the data for Hardwig Inc. If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy?A) $8,418B) $8,861C) $9,327D) $9,818E) $10,309

D) $9,818

Explanation:

This can be determined using the following 3 steps.

Step 1. Calculation of interest expense under a restricted policy

Sales = $3,600,000

Asset turnover = Sales/ Total assets = 2.5 (1)

Substituting sales into equation (1) and solve for Total assets, we have:

$3,600,000/ Total assets = 2.5

Total assets = $3,600,000 / 2.5

Total assets = $1,440,000

Since Debt is 50% of Total assets, we therefore have:

Debt = 50% * Total assets = 50% * $1,440,000 = $720,000

Since the interest rate on the firm's debt is 10%, we have:

Interest expense under a restricted policy = 10% * Debt = 10% * $720,000 = $72,000

Step 2. Calculation of interest expense under a relaxed policy

Sales = $3,600,000

Asset turnover = Sales/ Total assets = 2.2 (1)

Substituting sales into equation (1) and solve for Total assets, we have:

$3,600,000/ Total assets = 2.2

Total assets = $3,600,000 / 2.2

Total assets = $1,636,363.64

Since Debt is 50% of Total assets, we therefore have:

Debt = 50% * Total assets = 50% * $1,636,363.64 = 818,181.82

Since the interest rate on the firm's debt is 10%, we have:

Interest expense under a restricted policy = 10% * Debt = 10% * 818,181.82 = $81,818

Step 3. Calculation of difference between interest expense under a restricted policy and a relaxed policy

Difference between interest expenses = Interest expense under a restricted policy -  Interest expense under a relaxed policy = $81,818 - $72,000 = $9,818

Therefore, the interest expense under a relaxed policy would be $9,818 lower than interest expense under the relaxed policy.