   Chapter 4, Problem 21P Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

Solutions

Chapter
Section Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

P/E AND STOCK PRICE Fontaine Inc. recently reported net income of $2 million. It has 500,000 shares of common stock, which currently trades at$40 a share. Fontaine continues to expand and anticipates that 1 year from now, its net income will be $3.25 million. Over the next year, it also anticipates issuing an additional 150,000 shares of stock so that 1 year from now it will have 650,000 shares of common stock. Assuming Fontaine’s price/earnings ratio remains at its current level, what will be its stock price 1 year from now? Summary Introduction To determine: The stock price in 1 year, if price/earnings ratio remains at its current level. Earnings per Share (EPS): Earnings per share is the ratio of profit after tax and number of outstanding equity share. It is the amount earned by each equity shares of the company. Earnings per share determine the profitability of the firm in terms of equity shares. The formula to calculate earnings per share is: Earnings Per Share=Profit After TaxTotal Outstanding Shares Price Earnings Ratio (P/E Ratio): The ratio earnings per share and market price of a share is called price earnings ratio. This ratio indicates that to earn one rupee, how much money an investor need to investor in that particular share. The formula of price earnings ratio is: P/E Ratio=Market Price Per ShareEarnings Per Share Explanation Solution: Given, Price earnings ratio of current level is 10 times. New EPS of year 1 is 5 per share. The formula of price earnings ratio is, P/E Ratio=Market Price Per ShareEarnings Per Share Substitute 10 times for P/E ratio and$5 for earnings per share.

10times=Market Price Per Share$5Market Price Per Share=$50 per share

Working notes:

Compute current EPS and P/E ratio.

Profit after tax is $2,000,000. Number of outstanding shares are 500,000. The formula to calculate EPS is, Earnings Per Share=Profit After TaxTotal Outstanding Shares Substitute$2,000,000 for profit after tax and 500,000 for total outstanding share.

Earnings Per Share=$2,000,000500,000shares=$4per share

Compute current P/E ratio of the share

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