Question

FINA 3320: Corporate Finance

Project 3: Risk and Return

Equity Eddie’s Company Net Income Forecast (in 000’s)

	Probability of Occurrence
	5%	10%	70%	10%	5%
Operating Income	$100	$200	$400	$600	$700
Interest Expense	0	0	0	0	0
Before-Tax Income	$100	$200	$400	$600	$700
Taxes (28%)	$28	$56	$112	$168	$196
Net Income	$72	$144	$288	$432	$504

Barry Borrower’s Company Net Income Forecast (in 000’s)

	Probability of Occurrence
	5%	10%	70%	10%	5%
Operating Income	110	220	440	660	770
Interest Expense	40	40	40	40	40
Before-Tax Income	70	180	400	620	730
Taxes (28%)	20	50	112	174	204
Net Income	50	130	288	446	526

Please show how you got the answer

1.Calculate the expected values of Equity Eddie’s and Barry Borrower’s net incomes.

2. Calculate the standard deviations of Equity Eddie’s and Barry Borrower’s netincomes.

3. Calculate the coefficients of variation of Equity Eddie’s and Barry Borrower’s netincomes.

4. Compare Equity Eddie’s and Barry Borrower’s degrees of financial risk, which firm do you prefer?

Answer 1

1.

Equity Eddie’s Company('000)
Net Income	Proabaility	Expected value
72	0.05	3.6
144	0.1	14.4
288	0.7	201.6
432	0.1	43.2
504	0.05	25.2
	Total	288

Barry Borrower’s Company('000)
Net Income	Proabaility	Expected value
50	0.05	2.5
130	0.1	13
288	0.7	201.6
446	0.1	44.6
526	0.05	26.3
	Total	288

2.

Equity Eddie’s Company('000)
Given	Expected	Given-Expected	(Given-Expected)^2(A)	probability(B)	A*B
72	288	-216	46656	0.05	2332.8
144	288	-144	20736	0.1	2073.6
288	288	0	0	0.7	0
432	288	144	20736	0.1	2073.6
504	288	216	46656	0.05	2332.8
				Total	8812.8

standard deviation =square root of 8812.8 = 93.88

Barry Borrower’s Company('000)
Given	Expected	Given-Expected	(Given-Expected)^2(A)	probability(B)	A*B
50	288	-238	56644	0.05	2832.2
130	288	-158	24964	0.1	2496.4
288	288	0	0	0.7	0
446	288	158	24964	0.1	2496.4
526	288	238	56644	0.05	2832.2
				Total	10657.2

standard deviation =square root of 10657.2 = 103.23

3. coefficients of variation= standard deviation/expected value

So coefficients of variation of Equity Eddie’s = 93.88/288 = 0.32597

& coefficients of variation of  Barry Borrower’s=

103.23/288 = 0.35845

4. Since coefficients of variation of  Barry Borrower’s is greator than coefficients of variation of Equity Eddie’s so Barry Borrower is more risky therefore i will prefer Equity Eddie’s.