River Cruises is all-equity-financed with 100,000 shares. It now proposes to iss

Question

River Cruises is all-equity-financed with 100,000 shares. It now proposes to issue $220,000 of debt at an interest rate of 12% and use the proceeds to repurchase 22,000 shares at $10 per share. Profits before interest are expected to be $122,000.

a. What is the ratio of price to expected earnings for River Cruises before it borrows the $220,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is the ratio after it borrows? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Explanation / Answer

Answer a Price to expected earnings ratio = Market price per share / Expected Earnings per share Market price per share = $10 Expected Earnings per share = (Profit before Interest - Interest) / No.of equity shares outstanding Expected Earnings per share = ($122000 - $0) / 100000 shares = $1.22 per share Price to expected earnings ratio for River Cruises before it borrows the $220,000 = $10 / $1.22 = 8.20 Answer b Price to expected earnings ratio = Market price per share / Expected Earnings per share Market price per share = $10 Expected Earnings per share = (Profit before Interest - Interest) / No.of equity shares outstanding Interest Expense = $220000*12% = $26400 No.of equity shares outstanding after repurchase = 100000 shares - 22000 shares = 78000 shares Expected Earnings per share = ($122000 - $26400) / 78000 shares = $1.23 per share Price to expected earnings ratio for River Cruises after it borrows the $220,000 = $10 / $1.23 = 8.16

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