Question

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 here:

Sterling				Royal
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

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.)

Stock Price___ ?

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 answers to 2 decimal places.)

	Stock Price   Sterling $ Royal $

Answer 1

Req a:
Earning per share
			Sterling	Royal
Earnings before interest and tax			129800	129800
Less: Interest			77880	25960
			(708000*11%)	(236000*11%)
Earnings before tax			51920	103840
Less: tax @ 30%			15576	31152
Earnings after tax			36344	72688
Divide: Number of shares			94400	188800
Earnings per share			0.385	0.385
Req b:
Earnings per share (of both the companies):				0.385
PE ratio:				19
Stock price of both the companies				7.315
Req c:
As Sterling is having high dets, it is morre risky therefore PE ratio for such company shall be 13
And Royal is low debt utilizing company and less riskier, Therefore PE ratio for such company is 22.
Thus,
Stock price of Sterling = PE ratio *EPS = 13*0.385 = 5.01
Stock price of Royal = PE ratio*EPS = 22*0.385 = 8.47