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 $10000000 $10000000Total equity (all common) 9000000 5000000Total debt 1000000 5000000Annual interest 100000 500000Total sales $25000000 $25000000EBIT 6250000 6250000Earnings available forCommon stockholders 3690000 3450000a.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 3Risk 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 ExpectedInvestment return risk indexX 14% 7%Y 12 8Z 10 9a.If Sharon wererisk-indifferentwhich investments would she select? Explain why.b.If she wererisk-aversewhich investments would she select? Why?c.If she wererisk-seekingwhich investments would she select? Why?d.Given the traditional risk preference behavior exhibited by financial managers which investment would be preferred? Why?P5 4Risk 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 BInitial investment $12000 $12000Annual rate of returnPessimistic 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 BInitial investment (CF0) $8000 $8000Outcome Annual cash inflows (CF)Pessimistic $ 200 $ 900Most likely 1000 1000Optimistic 1800 1100a.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 partsaandbprovide consistent views of the two projects? Explain.d.Which project do you recommend? Why?
