Overhaul Experts, Ltd. (OEL), specializes in taking underperforming companies to
ID: 2488220 • Letter: O
Question
Overhaul Experts, Ltd. (OEL), specializes in taking underperforming companies to a higher level of performance. OEL's capital structure at December 31, 2013, included 13,000 shares of $2.35 preferred stock and 110,000 shares of common stock. During 2014, OEL issued common stock and ended the year with 120,000 shares of common stock outstanding. Average common shares outstanding during 2014 were 116,000. Income from continuing operations during 2014 was $230,000. The company discontinued a segment of the business at a gain of $68,000, and an extraordinary item generated a loss of $47,000. All amounts are after income tax. Assume the number of preferred shares outstanding did not change in 2014. Requirements 1. Compute OEL's earnings per share. Start with income from continuing operations. 2. Analysts believe OEL can earn its current level of income for the indefinite future. Estimate the market price of a share of OEL common stock at investment capitalization rates of 7%, 9%, and 11%. Which estimate presumes an investment in OEL is the most risky? How can you tell? Requirement 1. Compute OEL's earnings per share. Start with income from continuing operations. Earnings per share: (116,000 average shares of common stock outstanding): Requirement 2. Analysts believe OEL can earn its current level of income for the indefinite future. Estimate the market price of a share of OEL common stock at investment capitalization rates of 7%, 9%, and 11%. Which estimate presumes an investment in OEL is the most risky? How can you tell? Begin by selecting the formula needed to estimate the market price of a share of the company's common stock using investment capitalization rates. Use the formula you determined above to calculate the estimated value of a share of the company's common stock at the various investment capitalization rates. Which estimate presumes an investment in Overhaul Experts stock is the most risky? How can you tell? The rate of presumes the investment is the most risky. You can tell, because at this rate investor is willing to pay the for the company's stock.Explanation / Answer
1.
Earnings per share from continued operations
= (Net income - Preferred dividend) / Average common shares outstanding
Where,
Net income = $230,000
Preferred dividends = $2.35 x 13,000 shares = $30,550
And,
Average common shares outstanding = 116,000
Therefore,
Earnings per share from continued operations = ($230,000 - $30,550) / 116,000 = $1.72
Earnings per share from discontinued operations
= Gain from discontiued operations / Average common shares outstadning
= $68,000 / 116,000
= $0.59
Earnings per share from extraordinary item = Extraordinary loss / Average common shares outstanding
= -$47,000 / 116,000
= -$0.41
Total earnings per share = $1.72 + $0.59 - $0.41 = $1.90
2.
Earnings per share from continued operations / Investment capitalization rate = Estimated value per share
Estimated value when capitalization rate is 7% = $1.72 / 0.07 = $24.57
Estimated value when capitalization rate is 9% = $1.72 / 0.09 = $19.11
Estimated value when capitalization rate is 11% = $1.72 / 0.11 = $15.63
A higher cap rate demanded by the market indicates a riskier proposition and hence a lower market value per share.
The rate of 11% presumes the investment is most risky. You can tell, because at this rate the investor is willing topay the lowest for the company's stock.
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