Question

Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $81,600. The separate capital structures for Sterling and Royal are shown here: Sterling Royal Debt @ 8% $ 612,000 Debt @ 8% $ 204,000 Common stock, $5 par 408,000 Common stock, $5 par 816,000 Total $ 1,020,000 Total $ 1,020,000 Common shares 81,600 Common shares 163,200

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 18 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 12 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

a) Statement showing EPS of both firms

Particulars	Sterling Optical	Royal Optical
EBIT	81600	81600
Less: Interest @ 8%	48960	16320
EBT	32640	65280
Less: Tax @ 20%	6528	13056
PAT	26112	52224
No of shares	81600	163200
EPS	0.32	0.32

b) Statement showing MPS

Particulars	Sterling Optical	Royal Optical
EPS	0.32	0.32
PE ratio	18	18
MPS= EPS*PE ratio	5.76	5.76

c) Statement showing MPS

Particulars	Sterling Optical	Royal Optical
EPS	0.32	0.32
PE ratio	12	20
MPS= EPS*PE ratio	3.84	6.4