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P3-21 Pelican paper Inc and Timberland Forest

The relationship between financial leverage and profitability Pelican 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.

ItemPelican paper IncTimberland forest Inc
Total assets$10000000$10000000
Total Equity (all common)90000005000000
Total debt10000005000000
Annual interest100000500000
Total sales2500000025000000
EBIT62500006250000
Earnings available for common stockholders36900003690000

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.

Debt ratio

Times interest earned ratio

Calculate the following profitability ratios for the two companies. Discuss their profitability relative to one another.

Operating profit margin

Net profit margin

Return on total assets

Return on common equity

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?

Solution:

a.Pelican Paper, Inc.Timberland Forest, Inc.
1. Debt RatioTotal Debt/Total Assets10.0%50.0%
2. Times Interest earned RatioEBIT/Annual interest62.5012.50
b.
1. Operating Profit MarginEBIT*100/Sales25.0%25.0%
2. Net profit marginEarnings available for shareholders*100/Sales14.76%13.80%
3. Return on total assetsEarnings available for shareholders*100/Total Assets36.90%34.50%
4. Return on Common equityEarnings available for shareholders*100/Total Equity41.00%69.00%

c.

Timberland has lower interest payments to make than Pelican therefore the resulting profits of Timberland is higher. Timberland has high debt ratio as much as 5 times of Pelican which poses it to financial risk. Therefore, if anyone is preferring Timberland over Pelican she will be investing in a riskier resort. Timberland is under the risk that it may default and the may not be able to pay the interests and the capital amount of the capital. Which may force the company towards liquidation. Therefore, Timberland is higher in the financial risk context therefore anyone investing in this company will face the same risk.

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