5 one firm uses a higher degree of financial leverage

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5. One firm uses a higher degree of financial leverage, and yet their return on equity is similar to that of the other firm. Discuss the other factors that impact return on equity with respect to Firms A and B. 6. Identify two limitations of financial ratio analysis. Question 2.24 - Edmonds Edmonds Manufacturing is located in the northwest region of the U.S. The company is experiencing tremendous growth in demand for its products. Management has discussed the distribution channel as an impediment to the company’s ability to keep up with growing demand. Manufacturing facilities have excess capacity to meet increasing orders, but the company will have difficulty getting the products to the customers. The supply chain distribution manager has suggested the company purchase a new building to expand the storage area near the distribution center. After some collaborative research by the accounting and finance departments, the company found that a new building will cost $25,000,000. The new building will have an estimated useful life of ten years with no salvage value. Operating the new building will cost approximately $1,000,000 per year but the new building will allow the company to increase sales significantly. Distribution managers believe the new building will increase productivity to allow for additional sales of 500,000 units each year. Marketing managers estimate the demand for the company’s product will increase 750,000 units each year. The average contribution margin for the company’s products is $55. The company’s effective income tax rate is 40%. REQUIRED: 1. a. Define capital budgeting. b. What two steps should Edmonds take in evaluating and implementing this project? 2. What are two qualitative factors Edmonds should consider before implementing this project? 3. Identify the relevant cash flows for the project on both a pretax and an after-tax basis. Show your calculations. 4. a. Define Net Present Value (NPV). b. Define Internal Rate of Return (IRR). c. Identify one assumption of NPV and one assumption of IRR. d. Discuss the decision criteria used in NPV and IRR to determine acceptable projects. 5. Explain one advantage and one disadvantage of IRR.
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369 6. a. Define the payback method b. Identify and explain two disadvantages of the payback method. Question 2.25 - Vista Vista Ltd., a closely-held firm, is trying to determine a benchmark for its cost of equity. Comparable firms in the industry have a price/earnings ratio of 11, an average beta value of 1.05, a dividend payout ratio of 40% of earnings, and a projected growth rate of 10%. For the fiscal year just ended, Vista had earnings per share of $3.00 and is expected to achieve the industry average growth rate in the coming year. Economic indicators show the risk-free rate is 5% and the return on the market is 15%.
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