Question

River Cruises is all-equity-financed with 100,000 shares. It now proposes to issue $220,000 of debt at an interest rate of 12% and use the proceeds to repurchase 22,000 shares at $10 per share. Profits before interest are expected to be $122,000. a. What is the ratio of price to expected earnings for River Cruises before it borrows the $220,000? (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

Answer :

a) First, we should know the Earnings per share (EPS) as it is calculated below:

EPS = Profit before tax / No. of shares

= 122,000 / 100,000

= 1.22

Now,

Price Earnings Ratio = Price of share / EPS

= 10 / 1.22

= 8.20

b) After debt issue, interest expense = 220,000 * 12% = 26,400

Net income = 122,000 - 26,400 = 95,600

EPS = Net income / Number of shares

= 95,600 / ( 100,000 - 22,000 )

= 1.23

Price Earnings Ratio = 10 / 1.23

Price Earnings Ratio = 8.13