Sterling Optical and Royal Optical both make glass frames and each is able to ge

Question

Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $136,000. The separate capital structures for Sterling and Royal are shown here:

a. Compute earnings per share for both firms. Assume a 30 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 21 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 15 for the riskier company in terms of heavy debt utilization in the capital structure and 25 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

Sterling Royal Debt @ 10% $ 816,000 Debt @ 10% $ 272,000 Common stock, $5 par 544,000 Common stock, $5 par 1,088,000 Total $ 1,360,000 Total $ 1,360,000 Common shares 108,800 Common shares 217,600

Explanation / Answer

Solution:

Particulars Sterling Royal Earning before interest and taxes 1,36,000 1,36,000 Less: interest 81,600 27,200 Earning before tax 54,400 1,08,800 Less : Tax @30% 16,320 32,640 Earning after tax(A) 38,080 76,160 Number of shares(B) 108800 217600 a) Earning per share( EPS)=(A)/(B) 0.35 0.35 b) P/E ratio 21 21 Stock price = P/E ratio *EPS 7.35 7.35 C) P/E ratio* 15 25 Stock price = P/E ratio*EPS 5.25 8.75 * Debt utilisation = Debt/total capital 0.62 0.20 Riskier

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