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 $132,000. The separate capital structures for Sterling and Royal are shown next: Compute earnings per share for both firms. Assume a 25 percent tax rate. (Round your answers to 2 decimal places.) In part a, you should have gotten the same answer for both companies' earnings per share. Assuming a P/E ratio of 22 for each company, what would its stock price be? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Now as part of your analysis, assume the P/E ratio would be 16 for the riskier company in terms of heavy debt utilization in the capital structure and 24 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.)

Explanation / Answer

a) Earning per share of Sterling =(132,000-12%*660,000)*(1-25%)/132,000 =$ 0.3

Earning per share of Royal =(132000-12%*220,000)*(1-25%)/220000 =$ 0.36

b)Price of the stock = P/E* Earning per share = 0.36*22=$7.92

c)Sterling is riskier as it has higher debt utilization

Stock price of Sterling = 16*0.36=$5.76

Stock price of Royal = 24*0.36=$8.64

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