Problem 16-4 Leverage and P/E Ratios (LO1) River Cruises is all-equity-financed

Question

Problem 16-4 Leverage and P/E Ratios (LO1) River Cruises is all-equity-financed with 100,000 shares. It now proposes to issue $260,000 of debt at an interest rate of 12% and use the proceeds to repurchase 26,000 shares at $10 per share. Profits before interest are expected to be $126,000. a. What is the ratio of price to expected earnings for River Cruises before it borrows the $260,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Price-earnings ratio b. What is the ratio after it borrows? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Price-earnings ratio

Explanation / Answer

A,)

Without debt:
Expected earnings per share   = Net profits / Number of shares
= $129,000 / 100,000
= $1.29

P/E ratio   = Price per share / Earnings per share
= $10 / 1.29
= 7.75

7.75 +/- 1%

B.)
With debt:
Expected earnings per share   = Net profits / Number of shares
= [$129,000 – (.10 × $290,000)] / (100,000 – 29,000)
= $1.408

P/E ratio   = Price per share / Earnings per share
= $10 / 1.408
= 7.10

The P/E ratio decreases because the equity is now riskier. Although earnings per share increase, the market value of each share remains constant. The increase in risk offsets the increase in expected earnings.

River Cruises is all-equity-financed.

The common stock and debt of Northern Sludge are valued at $63 million and $37 million, respectively

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