Question

Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $136,000. The separate capital structures for Sterling and Royal are shown here:

Sterling				Royal
Debt @ 10%	$	816,000		Debt @ 10%	$	272,000
Common stock, $5 par		544,000		Common stock, $5 par		1,088,000
Total	$	1,360,000		Total	$	1,360,000
Common shares		108,800		Common shares		217,600

a. Compute earnings per share for both firms. Assume a 30 percent tax rate. (Round your answers to 2 decimal places.)
  

b. In part a, you should have gotten the same answer for both companies’ earnings per share. Assuming a P/E ratio of 21 for each company, what would its stock price be? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
  

c. Now as part of your analysis, assume the P/E ratio would be 15 for the riskier company in terms of heavy debt utilization in the capital structure and 25 for the less risky company. What would the stock prices for the two firms be under these assumptions? (Note: Although interest rates also would likely be different based on risk, we will hold them constant for ease of analysis.) (Do not round intermediate calculations. Round your answers to 2

Answer 1

Solution:

Particulars	Sterling	Royal
Earning before interest and taxes	1,36,000	1,36,000
Less: interest	81,600	27,200
Earning before tax	54,400	1,08,800
Less : Tax @30%	16,320	32,640
Earning after tax(A)	38,080	76,160
Number of shares(B)	108800	217600
a) Earning per share( EPS)=(A)/(B)	0.35	0.35
b) P/E ratio	21	21
Stock price = P/E ratio *EPS	7.35	7.35
C) P/E ratio*	15	25
Stock price = P/E ratio*EPS	5.25	8.75
* Debt utilisation = Debt/total capital	0.62	0.20
	Riskier