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 $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?

Answer 1

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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