Question

Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $151,800. The separate capital structures for Sterling and Royal are shown here:

Sterling				Royal
Debt @ 11%	$	828,000		Debt @ 11%	$	276,000
Common stock, $5 par		552,000		Common stock, $5 par		1,104,000
Total	$	1,380,000		Total	$	1,380,000
Common shares		110,400		Common shares		220,800

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 22 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 16 for the riskier company in terms of heavy debt utilization in the capital structure and 20 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