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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 here:

Sterling		Royal
Debt @12%	\)660,000	Debt @12%	\(220,000
Common stock, \)5 par	440,000	Common stock, \(5 par	880,000
Total	\)1,100,000	Total	$1,100,000
Common shares	88,000	Common shares	176,000

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? (Note: Although interest rates also would likely be different based on risk, we will hold them constant for ease of analysis.)

Step by step solution

01

Classification of the companies as the riskier company and the less risky company

The sterling optical consists of debt more than the royal opticals. Hence, Sterling optical is more risky than the royal optical.

02

Stock price of sterling opticals

$\begin{array}{rcl}\mathrm{Stock}\mathrm{price}& =& \mathrm{EPS}×\mathrm{P}/\mathrm{E}\mathrm{ratio}\\ & =& \$0.45×16\\ & =& \$7.20\end{array}$

03

Stock price of royal opticals

$\begin{array}{rcl}\mathrm{Stock}\mathrm{price}& =& \mathrm{EPS}×\mathrm{P}/\mathrm{E}\mathrm{ratio}\\ & =& \$0.45×24\\ & =& \$10.80\end{array}$

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