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 $645,000 per year; if he works a 50-hour week, the company's EBIT will be $815,000 per year. The company is currently worth $4.15 million. The company needs a cash infusion of $2.25 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? (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	$ 465,000 465,000 Incorrect
50-hour week	$ 635,000 635,000 Incorrect

Scenario-2
Equity issue:

	Cash flows
40-hour week	$ Not attempted
50-hour week	$ Not attempted

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

Equity issue

Debt issue

Answer 1

Answer a
Scenario-1 - Debt Issue
Interest on debt = Cash infusion * debt interest rate
Interest on debt = $22,50,000 * 9% = $2,02,500
Hours per week	EBIT	Interest	Cash flow
A	B	C	B-C
40 hour week	$645,000.00	$202,500.00	$442,500.00
50 hour week	$815,000.00	$202,500.00	$612,500.00
Scenario-2 -Equity Issue
Hours per week	EBIT	Interest	Cash flow
A	B	C	B-C
40 hour week	$645,000.00	$0.00	$645,000.00
50 hour week	$815,000.00	$0.00	$815,000.00
Answer b
Cash flow under Equity option is higher compared to debt option.
Hence Tom will likely to work harder under Equity issue option.