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 $635,000 per year; if he works a 50-hour week, the company's EBIT will be $795,000 per year. The company is currently worth $4.05 million. The company needs a cash infusion of $2.15 million, and it can issue equity or issue debt with an interest rate of 7 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.)

Scenario-1
Debt issue:

	Cash flows
40-hour week	$
50-hour week	$

Scenario-2
Equity issue:

	Cash flows
40-hour week	$
50-hour week	$

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

Debt issue

Equity issue

Answer 1

a) Debt Issue

Cash Flow = EBIT - Interest expense

40 - hour week = $635,000 - ($2,150,000 x 7%) = $484,500

50 - hour week = $795,000 - ($2,150,000 x 7%) = $644,500

Equity issue

In this case, their will be no interest cost but Tom's shareholding % will dilute.

Share of equity post issue = Tom's shares worth / Post issue firm value

or, Share of equity post issue = $4.05 million / ($4.05 + $2.15) million = 0.65322580645

Cash Flow to Tom = EBIT x share in equity

40 - hour week = $635000 x 0.65322580645 = $414,798

50 - hour week = $795000 x 0.65322580645 = $519,315

b) Tom is likely to work harder (50 - hour week) under Debt Issue.