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 $560,000 per year; if he works a 50-hour week, the company's EBIT will be $645,000 per year. The company is currently worth $3.3 million. The company needs a cash infusion of $1.4 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? (Enter your answers in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole number, 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?

A. Equity issue
B. Debt issue

Answer 1

Answer: Please refer to Explanation

Step-by-step explanation:

a) Scenario 1 - Debt Issue

Cash flow under Debt Issue is the Earnings before Interest and Tax less Interest as it is assumed that there are no taxes.

Cash Flow = EBIT - Interest expense

40-hour week = $560,000 - ($1,400,000 x 8%)

= $448,000

50-hour week = $645,000 - ($1,400,000 x 7%)

= $533,000

Scenario 2 - Equity issue

The cost to Tom here is the dilution of his shares. Therefore the Cash flow is the income * his share in the company.

Tom share of Equity After Issue= Tom's Shares Worth / Post Issue Firm Value

= $3.3 million / (3.3 + 1.4)

= 0.702

As earlier mentioned, Tom's cash flow is,

Cash Flow to Tom = EBIT x share in equity

40-Hour Week = 560,000 * 0.702

= $393,120

50-Hour Week = 645,000 * 0.702

= $452,790

b) Should Tom work harder under a Debt Issue, he makes more money than if he works harder under an Equity issue therefore he is likely to work harder under the DEBT Issue.