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 $610,000 per year; if he works a 50-hour week, the company's EBIT will be $745,000 per year. The company is currently worth $3.8 million. The company needs a cash infusion of $1.9 million and can issue equity or issue debt with an interest rate of 10 percent. Assume there are no corporate taxes.

  

a.	What are the cash flows to Tom under each scenario? (Do not round intermediate calculations and enter your answers in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.)
	Under which form of financing is Tom likely to work harder? A) debt issue and 40-hr week debt issue and 50-hr week equity issue and 40-hr week equity issue and 50-hr week B) Which form of financing is tom likely to work harder?

Answer 1

A)
Cash flow if debt is issued and tom works for 40 hr per week
If debt is issued company will have to pay interest on the debt
Calculation of interest on the debt
Interest = ($1.9 million*10%)
Interest	$190,000
Cash flow to Tom in case of debt issue would be EBIT less interest payments
Cash flow calculation
Cash flow = 610,000-190,000
Cash flow	$420,000
The cash flow to tom would be $420,000 in case debt is issued and he works for 40 hr week
If debt is issued and tom works for 50 hr week
Cash flow	745000-190000
Cash flow	$555,000
The cash flow to tom would be $555,000 in case debt is issued and he works for 50 hr week
If equity is issued, the ownership of Tom would be reduced from 100%
New ownership of tom = 3800000/(3800000+1900000)	66.67%
If tom works 40 hr week, cash flow = 610000*66.67%	$406,666.67
If equity is issued and tom works for 40 hr week, cash flow would be $406,666.67
If tom works 50 hr week, cash flow = 745000*66.67%	$496,666.67
If equity is issued and tom works for 50 hr week, cash flow would be $496,666.67
B.
Tom would work harder for debt financing as the cash flow tom would received in this case would be higher then that received under equity financing