Problem 5-18 Combining operating and financial leverage [LO5]

Sterling Optical and Royal Optical both make glass frames and each is able to generate earnings before interest and taxes of $116,000. The separate capital structures for Sterling and Royal are shown below:

Sterling

Royal

Debt @ 10%	$	696,000	Debt @ 10%	$	232,000
Common stock, $5 par		464,000	Common stock, $5 par		928,000
Total	$	1,160,000	Total	$	1,160,000
Common shares		92,800	Common shares		185,600

(a)	Compute earnings per share for both firms. Assume a 25 percent tax rate. (Round your answers to 2 decimal places. Omit the "$" sign in your response.)

	Earnings per share
Sterling	$
Royal	$

(b)	In part a, you should have gotten the same answer for both companies' earnings per share. Assuming a P/E ratio of 18 for each company, what would its stock price be? (Use rounded Earnings per share.Round your answer to 2 decimal places. Omit the "$" sign in your response.)

Stock price

$

(c)

Now as part of your analysis, assume the P/E ratio would be 12 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.) (Use rounded Earnings per share. Round your answers to 2 decimal places. Omit the "$" sign in your response.)

	Stock price
Sterling	$
Royal	$