Question:
Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $120,000. The separate capital structures for Sterling and Royal are shown below:
Sterling Royals
Debt 12% 600,000 Debt 12% 200,000
Common stock,$5 per 400,000 Common stock, $5per 800,000
Total 1,000,000 Total 1,000,000
common shares 80,000 Commom shares 100,000
a. Compute earnings per share for both firms. Assume a 25 percent tax rate.
b. In part a, you should have gotten the same answer for both companies’ earnings per share. Assuming a P/E ratio of 20 for each company, what would its stock price be?
c. 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 25 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.)
d. Based on the evidence in part c, should management only be concerned about the impact of financing plans on earnings per share, or should stockholders’ wealth maximization (stock price) be considered as well?