Question

River Cruises is all-equity-financed with 100,000 shares. It now proposes to issue $280,000 of debt at an interest rate of 12% and use the proceeds to repurchase 28,000 shares at $10 per share. Profits before interest are expected to be $128,000.

a. What is the ratio of price to expected earnings for River Cruises before it borrows the $280,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is the ratio after it borrows? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

a. The ratio is computed as shown below:

= Price per share / Earnings per share

Earnings per share is computed as follows:

= Profit before interest / Number of shares outstanding

= $ 128,000 / 100,000

= $ 1.28

So, the ratio will be computed as follows:

= $ 10 / $ 1.28

= 7.81 Approximately

b. The ratio is computed as shown below:

= Price per share / Earnings per share

Earnings per share is computed as follows:

= (Profit before interest - interest) / (Number of shares outstanding - share repurchased)

= ($ 128,000 - $ 280,000 x 12%) / (100,000 - 28,000)

= $ 1.31 Approximately

So, the ratio will be computed as follows:

= $ 10 / $ 1.31

= 7.63 Approximately

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