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 $550,000 per year; if he works a 50-hour week, the company's EBIT will be $625,000 per year. The company is currently worth $3.2 million. The company needs a cash infusion of $1.3 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 whole dollars, not millions of dollars. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))

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 or Equity issue

Answer 1

Particulars	40 Hours/Week	50 Hours/Week
Debt Issue
EBIT	550,000	625,000
Less - Interest at 7 percent	-91,000	-91,000
Cashflow from operating activities - A	459,000	534,000
Cashflow from Issue of Debt	1,300,000	1,300,000
Cashflow from financing activities - B	1,300,000	1,300,000
Total Cash Flow A+B	1,759,000	1,834,000

Particulars	40 Hours/Week	50 Hours/Week
Equity Issue
EBIT	550,000	625,000
Cashflow from operating activities - A	550,000	625,000
Cashflow from Issue of Equity	1,300,000	1,300,000
Cashflow from financing activities - B	1,300,000	1,300,000
Total Cash Flow A+B	1,850,000	1,925,000

Part b - Since cash flows under Debt Issue are lesser than under equity issue, Tom will have to work harder under Debt Issue.