Question

Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the company's profits are driven by the amount of work Tom does. If he works 40 hours each week, the company's EBIT will be $600,000 per year, if he works a 50-hour week, the company's EBIT will be $725,000 per year. The company is currently worth $3.7 million. The company needs a cash infusion of $1.8 million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume there are no corporate taxes. a. What are the cash flows to Tom under each scenario? (Enter your answers in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) Scenario-1 Debt issue Cash flows 40-hour week 50-hour week Scenario-2 Equity issue: Cash flows A 40-hour week 50-hour week A b. Under which form of financing is Tom likely to work harder? Debt issue Equity issue

Answer 1

a) Interest expense 144,000 =1800000*8% Scenario-1 Debt issue: Cash flows 40-hour week EBIT-Interest expense | $ 581,000 1–725000-144000 50-hour week EBIT-Interest expense $ 456,000 -600000-144000 Total ownership percentage 67.27% =3700000/(3700000+1800000) Scenario - 2: Equity issue: 40-hour week EBITXOwnership % 50-hour week EBITxOwnership % $ 487,708 -725000*67.27% $ 403,620 =600000*67.27% b) Tom will work hard in debt issue. (Tom will gain more)

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