Question

1. 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 $480,000 per year; if he works a 50-hour week, the company’s EBIT will be $550,000 per year. The company is currently worth $3.3 million. The company needs a cash infusion of $1.7 million, and it can issue equity or issue debt with an interest rate of 9 percent. Assume there are no corporate taxes.

a. What are the cash flows to Tom under each scenario?

b. Under which form of financing is Tom likely to work harder?

Please include detailed calculation steps.

Answer 1

Answer-

a). Debt issue:

The company needs a cash infusion of $1.4 million. If the company issues debt, the annual interest payments will be:

Interest = $1,700,000(0.09) = $153,000

The cash flow to the owner will be the EBIT minus the interest payments, or:

40-hour week cash flow = $480,000 - $153,000 = $327,000

50-hour week cash flow = $550,000 - $153,000 = $397,000

Equity issue:

If the company issues equity, the company value will increase by the amount of the issue. So, the current owner's equity interest in the company will decrease to:

Tom's ownership percentage = $3,300,000/($3,300,000 + $1,700,000) = 0.66

So, Tom's cash flow under an equity issue will be 66 percent of EBIT, or:

40-hour week cash flow = 0.66($480,000) = $316,800

50-hour cash flow = 0.66($550,000) = $363,000

b). Tom will work harder under the debt issue since his cash flows will be higher. Tom will gain more under this form of financing since the payments to bondholders are fixed. Under an equity issue, new investors share proportionally in his hard work, which will reduce his propensity for this additional work