Question

Attempts: Keep the Highest: 12 4. Understanding business and financial risks Aa Aa E The total risk in a firm is determined by evaluating the firm's business risk and financial risk. As an analyst, Olivia is comparing two nearly identical manufacturing firms: Purple Panda Manufacturing Company and Teal Camel Production Inc. It is your job to evaluate the relative business and financial risks of Purple Panda and Teal Camel. The two firms have the same level of total assets and expected net operating profit after taxes (NOPAT), but they differ in two critical characteristics: total debt and the standard deviation of the expected NOPAT. The following table outlines some of Purple Panda's and Teal Camel's major attributes: Total assets Total debt Expected NOPAT Standard deviation of expected NOPAT Purple Panda Teal Camel Manufacturing Inc. Production Inc. $5,200,000 $5,200,000 $2,860,000 $1,040,000 $1,248,000 $1,248,000 $202,800 $301,600 Use the given financial data to indicate which firm has the higher degree of each type of risk. Which firm has more business risk Purple Panda Teal Camel Which firm has more financial risk? Purple Panda Teal Camel

Answer 1

Since the total assets of both the companies are the same therefore the company with a higher level of debt financing/total debt has a greater probability of not meeting its debt obligations and has a higher Financial Risk. Hence, Purple Panda has more financial risk.

Higher the standard deviation, the riskier it is. Since the expected NOPAT of both the companies is the same but the standard deviation of expected NOPAT is higher for Tea Camel, therefore, Tea Camel has more Business Risk.