Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $168,000. The separate capital structures for Sterling and Royal are shown here: Sterling Royal $ 280,000 Debt @ 12% Common stock, $5 par 840, 000 Debt @ 12% 560,000 Common stock, $5 par $1,400, 000 Total 112, 000 Common shares 1,120,000 $1,400,000 224,000 Total Common shares a. Compute earnings per share for both firms. Assume a 25 percent tax rate. (Round your answers to 2 decimal places.) Earnings per Share Sterling $ 0.45 Royal $ 0.45 b. In part a, you should have gotten the same answer for both companies' earnings per share. Assuming a P/E ratio of 23 for each company, what would its stock price be? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Stock price $ 10.35 ....... c. Now as part of your analysis, assume the P/E ratio would be 17 for the riskier company in terms of heavy debt utilization in the capital structure and 21 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
Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $168,000. The separate capital structures for Sterling and Royal are shown here: Sterling Royal $ 280,000 Debt @ 12% Common stock, $5 par 840, 000 Debt @ 12% 560,000 Common stock, $5 par $1,400, 000 Total 112, 000 Common shares 1,120,000 $1,400,000 224,000 Total Common shares a. Compute earnings per share for both firms. Assume a 25 percent tax rate. (Round your answers to 2 decimal places.) Earnings per Share Sterling $ 0.45 Royal $ 0.45 b. In part a, you should have gotten the same answer for both companies' earnings per share. Assuming a P/E ratio of 23 for each company, what would its stock price be? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Stock price $ 10.35 ....... c. Now as part of your analysis, assume the P/E ratio would be 17 for the riskier company in terms of heavy debt utilization in the capital structure and 21 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
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Transcribed Image Text:# Educational Content on Capital Structure Analysis
## Overview
Sterling Optical and Royal Optical both manufacture glass frames and are capable of generating earnings before interest and taxes (EBIT) of $168,000. The capital structures of Sterling and Royal are detailed in the table below:
### Capital Structures
| | Sterling | Royal |
|----------------|-------------------|-------------------|
| Debt @ 12% | $840,000 | $280,000 |
| Common stock, $5 par | $560,000 | $1,120,000 |
| Total | $1,400,000 | $1,400,000 |
| Common shares | 112,000 | 224,000 |
## Analysis
### a. Compute Earnings Per Share (EPS)
Assume a 25% tax rate. The earnings per share for both Sterling and Royal are calculated as follows:
| Earnings per Share | |
|--------------------|-----------|
| **Sterling** | $0.45 |
| **Royal** | $0.45 |
### b. Stock Price Calculation
Given that you obtained the same EPS for both companies in part (a), if the Price-to-Earnings (P/E) ratio is 23, the stock price is calculated as:
| Stock Price | |
|-------------|------|
| | $10.35 |
### c. Adjusted Stock Price with Risk Consideration
Assume a P/E ratio of 17 for the riskier company with higher debt (Sterling) and 21 for the less risky company (Royal). Calculate the stock prices based on these assumptions:
| Stock Price | |
|-------------|---------|
| **Sterling**| |
| **Royal** | |
This analysis demonstrates the impact of capital structure and risk on stock valuation.
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