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

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.

$Earning per share = \frac{Net income}{Number of shares}$

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.

$P / E ratio = \frac{Share price}{Earnings per share}$

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	Capable corporation	Muli-media inc
Net income	\(31,200	\)140,000
Sales	317,000	2,700,000
Total assets	402,000	965,000
Total debts	163,000	542,000
Stockholder’s equity	239,000	423,000

	20X1	20X2
Sales	\(3,230,000	\)3,370,000
Cost of goods sold	2,130,000	2,850,000
Gross profits	\(1,100,000	\)520,000
Selling and administrative expenses	298,000	227,000
Operating profits	\(802,000	\)293,000
Interest expense	47,200	51,600
Income before taxes	\(754,800	\)241,400
Taxes (35%)	264,180	84,490
Income after tax	\(490,620	\)156,910

	20X1	20X2
Sales	\(8,000,000	\)10,000,000
Cost of goods sold	6,000,000	9,000,000
Inventory	800,000	1,000,000

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

Step by step solution

Earning per share

Price/Earnings ratio

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