Question

# Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the...

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 \$600,000 per year; if he works a 50-hour week, the company's EBIT will be \$725,000 per year. The company is currently worth \$3.7 million. The company needs a cash infusion of \$1.8 million and can issue equity or issue debt with an interest rate of 8 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.) b. Under which form of financing is Tom likely to work harder?

Solution a.

 Case1. Debt Issue 40-Hour Week Cash Flow 456000 =600000-(0.08*1800000) 50-Hour Week Cash Flow 581000 =725000-(0.08*1800000) Case2. Equity Issue Equity Proportion 0.6727 =3700000/(3700000+1800000) 40-Hour Week Cash Flow 403620 =600000*0.6727 50-Hour Week Cash Flow 487708 =725000*0.6727

Solution b.

Tom will work harder under the scenario of Debt issue, as it will retain full ownership.

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