Pulp Paper Company and Holt Paper Company are able to generate earnings before interest and taxes of $150,000.
The separate capital structures for Pulp and Holt are shown below:
Debt @ 10% $ 800,000 Debt @ 10% $ 400,000
Common stock, $5 par 700,000 Common stock, $5 par 1,100,000
Total $1,500,000 Total $1,500,000
Common shares 140,000
Common shares 220,000
a. Compute earnings per share for both firms. Assume a 40 percent tax rate.
b. In part a, you should have gotten the same answer for both companies' earnings per share. Assume 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 15 for the riskier company in terms of heavy debt utilization in the capital structure and 26 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 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?
Capital structures for Pulp Paper Company and Holt Company are determined. The earnings per share for both firms with 40 percent tax rates are determined. The solution is in the attached excel file.