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:

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 22 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 24 for the less risky company. What would the stock prices for the two firms be under these assumptions?
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 aswell?

  • CreatedOctober 14, 2014
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