Leverage and stockholder wealth [LO4]
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Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $129,800. The separate capital structures for Sterling and Royal are shown next:
|
| Debt @ 11% |
$ |
708,000 |
Debt @ 11% |
$ |
236,000 |
| Common stock, $5 par |
|
472,000 |
Common stock, $5 par |
|
944,000 |
|
|
|
|
|
|
| Total |
$ |
1,180,000 |
Total |
$ |
1,180,000 |
| Common shares |
|
94,400 |
Common shares |
|
188,800 |
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| a. |
Compute earnings per share for both firms. Assume a 30 percent tax rate. (Round your answers to 2 decimal places.)
|
|
Earnings Per Share |
| Sterling |
$ |
| Royal |
$ |
|
| b. |
In part a, you should have gotten the same answer for both companies' earnings per share. Assuming a P/E ratio of 19 for each company, what would its stock price be? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
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| c. |
Now as part of your analysis, assume the P/E ratio would be 13 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 answer to 2 decimal places.)
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