Question

Denise peterborough is the owner, president, and primary salesperson for dp manufacturing. because of this, the company's profits are driven by the amount of work denise does. if she works 40 hours each week, the company's ebit will be $500,000 per year; if she works a 50-hour week, the company's ebit will be $600,000 per year. the company is currently worth $3.3 million. the company needs a cash infusion of $2.2 million, and it can issue equity, or issue debt with an interest rate of 7 percent. assume there are no corporate taxes. denise's cash flow under an 40-hour week equity issue scenario will be $346,000 and she is likely to work harder under a debt issue scenario.

a. What are the cash flows to Tom under each scenario?
b. Under which form of financing is Tom likely to work harder?
c. What specific new costs will occur with each form of financing?

Answer 1

The student's question about DP Manufacturing's financing options suggests Denise may work harder if debt with a 7% interest is issued due to the pressure of fixed payments. The exact cash flows for 'Tom' are not determined from the information given, and the mention of 'Tom' appears to be a typo. Issuing equity involves new costs like dilution of ownership, while debt financing comes with interest payments and default risk.

Step-by-step explanation:

The student has posed a question concerning financing options available to Denise Peterborough, the owner and president of DP Manufacturing, and the impact those options may have on cash flows and potential costs. There are two scenarios to consider:

• Issuing equity
• Issuing debt with a 7% interest rate

Denise's cash flow with an equity issue at a 40-hour workweek is $346,000, and it's suggested that she may work harder if debt were issued.

Cash flows to the student's hypothetical character 'Tom' under each scenario are not provided and seem to be a part of the question's typo. The character 'Tom' does not align with the provided scenario. Assuming the question refers to Denise, we would need the details of how many shares are issued or the structure of the debt to calculate her specific cash flow under the debt scenario. However, the principle of increased effort under debt financing (due to the pressure of fixed interest payments) suggests that she would work harder in the debt issue scenario.

Specific new costs with each form of financing include:

• Equity Financing: Dilution of ownership and potential pressure from new shareholders
• Debt Financing: Regular interest payments and the risk of default