Question;P2-20;The relationship between financial leverage and profitabilityPelican;Paper, Inc., and Timberland Forest, Inc., are rivals in the manufacture of;craft papers. Some financial statement values for each company follow. Use them;in a ratio analysis that compares the firms? financial leverage and;profitability.;Item;Pelican;Paper, Inc. Timberland;Forest, Inc.;Total assets $10,000,000;$10,000,000;Total equity;(all common) 9,000,000 5,000,000;Total debt 1,000,000;5,000,000;Annual interest;100,000;500,000;Total sales $25,000,000;$25,000,000;EBIT 6,250,000;6,250,000;Earnings;available for;Common stockholders 3,690,000 3,450,000;a.;Calculate the following debt and coverage ratios for the two;companies. Discuss their financial risk;and ability to cover the costs in relation to each other.;b.;Calculate the following profitability ratios for the two;companies. Discuss their profitability relative to each other.;c.;In what way has the larger debt of Timberland Forest made it more;profitable than Pelican Paper? What are the risks that Timberland?s investors;undertake when they choose to purchase its stock instead of Pelican?s?;P5?3;Risk preferencesSharon Smith, the;financial manager for Barnett Corporation, wishes to evaluate three prospective;investments: X, Y, and Z. Currently, the firm earns 12% on its investments;which have a risk index of 6%. The expected return and expected risk of the;investments are as follows;Expected;Expected;Investment return risk index;X 14% 7%;Y 12 8;Z 10 9;a.;If Sharon wererisk-indifferent,which;investments would she select? Explain why.;b.;If she wererisk-averse,which;investments would she select? Why?;c.;If she wererisk-seeking,which;investments would she select? Why?;d.;Given the traditional risk preference behavior exhibited by;financial managers, which investment would be preferred? Why?;P5?4;Risk analysisSolar Designs is considering an;investment in an expanded product line. Two possible types of expansion are;being considered. After investigating the possible outcomes, the company made;the estimates shown in the following table;Expansion;A Expansion;B;Initial;investment $12,000;$12,000;Annual;rate of return;Pessimistic;16% 10%;Most;likely 20% 20%;Optimistic;24% 30%;a.;Determine therangeof;the rates of return for each of the two projects.;b.;Which project is less risky? Why?;c.;If you were making the investment decision, which one would you;choose? Why? What does this imply about your feelings toward risk?;d.;Assume that expansion B?s most likely outcome is 21% per year and;that all other facts remain the same. Does this change your answer to partc?;Why?;P4-10 Basic scenario;analysisMurdock Paints is in the process;of evaluating two mutually exclusive additions to its processing capacity. The;firm?s financial analysts have developed pessimistic, most likely, and;optimistic estimates of the annual cash inflows associated with each project.;These estimates are shown in the table on page 488.;Project A Project;B;Initial;investment (CF0);$8,000 $8,000;Outcome Annual;cash inflows (CF);Pessimistic;$ 200 $;900;Most;likely 1,000 1,000;Optimistic;1,800 1,100;a.;Determine therangeof;annual cash inflows for each of the two projects.;b.;Assume that the firm? s cost of capital is 10% and that both;projects have 20-year lives. Construct a table similar to this for the NPVs for;each project. Include therange;of NPVs for each project.;c.;Do partsaandb;provide consistent views of the two projects? Explain.;d.;Which project do you recommend? Why?
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