Two capital goods manufacturing companies, Rock Island and Davenport, are virtually identical in all aspects of their operations-product lines, amount of sales, total size, and so on. The two companies differ only in their capital structures, as shown here:
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Rock Island
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Davenport
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Debt(8%)
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$ 400 million
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$ 100 million
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Common equity
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$ 600 million
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$ 900 million
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Number of common shares outstanding
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30 million
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45 million
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Each company has $1,000 million ($1 billion) in total assets.
Capital goods manufacturers typically are subject to cyclical trends in the economy. Suppose that the EBIT level for both companies is $100 million during an expansion and $60 million during a recession. (Assume a 40 percent tax rate for both companies.)
a. Calculate the earnings per share for both companies during expansion and recession.
b. Which stock is riskier? Why?
c. At what EBIT level are the earnings per share of the two companies identical?
d. Calculate the common stock price for both companies during an expansion if the stock market assigns a price-earnings ratio of 10 to Davenport and 9 to Rock Island.