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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 Timberlands investors
undertake when they choose to purchase its stock instead of Pelicans?

P53
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?

P54
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 Bs 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
firms 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?

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
$10,000,000Total equity
(all common) 9,000,000 5,000,000Total debt 1,000,000
5,000,000Annual interest
100,000
500,000Total sales $25,000,000
$25,000,000EBIT 6,250,000
6,250,000Earnings
available forCommon stockholders 3,690,000 3,450,000a.
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 Timberlands investors
undertake when they choose to purchase its stock instead of Pelicans?P53
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
ExpectedInvestment return risk indexX 14% 7%Y 12 8Z 10 9a.
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?P54
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
BInitial
investment $12,000
$12,000Annual
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 Bs 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
firms 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)
$8,000 $8,000Outcome Annual
cash inflows (CF)Pessimistic
$ 200 $
900Most
likely 1,000 1,000Optimistic
1,800 1,100a.
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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