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 $590,000 per year; if he works a 50-hour week, the company's EBIT will be $705,000 per year. The company is currently worth $3.6 million. The company needs a cash infusion of $1.7 million, and it can issue equity or issue debt with an interest rate of 10 percent. Assume there are no corporate taxes.

Required:
a. What are the cash flows to Tom under each scenario?
b. Under which form of financing is Tom likely to work harder?

Answer 1

a). The company requires a cash infusion of amount $ 1.70 million. If the company issues any debt, annual interest payments is :

Interest = $ 1,700,000

Interest = $ 170,000

The cash flow to the owner is EBIT - (the interest payment) :

40 hour week cash flow = $ 590,000 - $ 170,000

= $ 420,000

50 hour cash flow = $ 705,000 x 67.92%

= $478,836

b). Tom will be working harder under the debt issue as the cash flow will be higher. He will also gain more under this case of financing since the payments to the bond holders are fixed. Under this equity issue, the new investors share the proportionality in his hand work, which will reduce the propensity for his additional work.