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?
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?
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?
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 therangeof NPVs for each project.
c.Do parts a and b provide consistent views of the two projects? Explain.
d.Which project do you recommend? Why?