Question

Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $105,600. The separate capital structures for Sterling and Royal are shown here:

Sterling				Royal
Debt @ 8%	$	792,000		Debt @ 8%	$	264,000
Common stock, $5 par		528,000		Common stock, $5 par		1,056,000
Total	$	1,320,000		Total	$	1,320,000
Common shares		105,600		Common shares		211,200

a. Compute earnings per share for both firms. Assume a 20 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 19 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 13 for the riskier company in terms of heavy debt utilization in the capital structure and 23 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 decimal places.)
  

Answer 1

a)

Earning per share (EPS)

Particulars	Sterling	Royal
EBIT	$105600	$105600
Less: Interest expense	$792000 x 8% = $63360	$264000 x 8% = $21120
Earnings before tax	$42240	$84480
Less: Tax @20%	$8448	$16896
Net income (a)	$33792	$67584
No. of common stock outstanding (b)	105600	211200
EPS (a / b)	$0.32	$0.32

b) Share price = EPS x PE ratio = $0.32 x 19 = $6.08

c) Sterling is riskier company as it has more debt in its capital structure then Royal.

Sterling stock price = 13 x $0.32 = $4.16

Royal stock price = 23 x $0.32 = $7.36