Question

Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $156,000. The separate capital structures for Sterling and Royal are shown here Sterling Royal Debt @ 12% Common stock, $5 pars $ 780,000 Debt @ 12% $ 260,000 520.000 Common stock, $5 par Total Common shares $1,300,000 208,000 $1,300,000 Total 104,000 Common shares a. Compute earnings per share for both firms. Assume a 30 percent tax rate. (Round your answers to 2 decimal places.) Earnings per Share Sterlin Royal 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.) Stock price 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 22 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.) Stock Price Sterlin Roval

Answer 1

Amount in $ Sterling Royal EBIT Less: Interest Profit before Tax (PBT Less. Tax @ 30% Profit after Tax (PAT Common Shares Earnings Per Share EPS PAT/Common Shares 156,000156,000 31,200 62,400 124,800 37,440 87,360 104,000 208,000 0.42 93,600 18,720 43,680 0.42

b)

P/E Ratio = Price per Share / Earnings per share

Price per share = Earnings per share * P/E Ratio

Price per share = 0.42 * 18

So, Stock Price = $ 7.56

c)

Sterling being the heavy debt company, so its P/E would be 12 and Royal being with less debt would be with P/E of 22.

	Sterling	Royal
P/E Ratio	12	22
EPS in $	0.42	0.42
Stock Price in $ (EPS *P/E)	5.04	9.24