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Chapter 2: Q10DQ (page 143)

When you are considering two different financing plans, does being at the level where earnings per share are equal between the two plans always mean you are in different as to which plan is selected?

Short Answer

Expert verified

The equality point only determines the indifference point which is based on earnings per share. The ultimate goal of the company is the maximization of its market value of the company. Hence, the company should be concerned with how the company's earnings are valued. Two plans that have the same earnings per share may have different price-earnings ratios, particularly when there is a differential risk component involved because of debt.

Step by step solution

01

Earning per share

Earning per share of the company is computed by dividing the net income of the company by the number of shares of the company. It represents the net income earned per share of the company.

Earningpershare=NetincomeNumberofshares

02

Price/Earnings ratio 

The price earning ratio of the company is computed by an organization to determine the company's current share price relative to its earnings per share. While considering the different financial plans, a company should use this ratio when the EPS is equal for both plans. It is so because the P/E ratio is different for different financing plans due to the different risks involved.

P/Eratio=鈥�SharepriceEarningspershare

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Most popular questions from this chapter

Vriend Software Inc.鈥檚 book value per share is \(15.20. If earnings per share is\)1.88 and the firm鈥檚 stock trades in the stock market at 3.5 times book value pershare, what will the P/E ratio be? (Round to the nearest whole number.)

Using the income statement for Times Mirror and Glass Co., compute the following ratios:

The total assets for this company equal \(80,000. Set up the equation for the Du Pont system of ratio analysis, and compute c, d, and e.

c. Profit margin.

Times mirror and glass company

Sales

\)126,000

Less: Cost of goods sold

93,000

Gross profit

\(33,000

Less: selling and administrative expenses

11,000

Lease Expenses

4,000

Operating profit*

\)18,000

Less: Interest expenses

3,000

Earning before taxes

\(15,000

Less: Taxes (30%)

4,500

Earning after taxes

\)10,500

*equal income before interest and taxes

Frantic Fast Foods had earnings after taxes of $420,000 in 20X1 with 309,000 shares outstanding. On January 1, 20X2, the firm issued 20,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent.

a. Compute earnings per share for the year 20X1.

b. Compute earnings per share for the year 20X2.

In January 2007, the Status Quo Company was formed. Total assets were \(544,000, of which \)306,000 consisted of depreciable fixed assets. Status

Quo uses straight-line depreciation of \(30,600 per year, and in 2007 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been \)29,000 per year each of the last 10 years. Other assets have not changed since 2007.

a. Compute return on assets at year-end for 2007, 2009, 2012, 2014, and 2016.

(Use $29,000 in the numerator for each year.)

What is the difference between book value per share of common stock and market value per share? Why does this disparity occur?
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