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 can issue equity or issue debt with an interest rate of 10 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? Debt issue and 40-hour week Debt issue and 50-hour week Equity issue and 40-hour week Equity issue and 50-hour week Which form of financing is Tom likely to work harder? b.

Answer 1

a) Interest expense $ 170,0001700000* 10% Debt issue: Scenario 1 Cash flows $ 420,000590000-170000 40-hour week EBIT-Interest expense $ 535,000705000-170000 50-hour weekEBIT-Interest expense Total ownership percentage 67.92%3600000/(3600000+1700000) Scenario 2: Equity issue: $ 400,728590000* 67.92% 40-hour weekEBITxOwnership % $ 478,836705000*67.92% 50-hour weekEBITxOwnership % b) Tom will work hard in debt issue. (Tom will gain more)

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