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 $585,000 per year; if he works a 50-hour week, the company's EBIT will be $1.65 million, and it can issue equity or issue debt with an interest rate of 9 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

Answer:

a.

If debt is issued;

40 Hour week;

EBIT = $585,000

Cash flows to Tom = EBIT - Interest

Interest will be on the $1.65 million that needs to be borrowed so;

= 9% * 1,650,000

= $148,500

Cash Flow to Tom = 585,000 - 148,500

= $436,500

50 Hour Week

Cashflows to Tom = EBIT - Interest

= 695,000 - 148,500

= $546,500

If Equity is Issued;

Company is worth $3.55 million but a $1.65 million investment is needed. If equity is issued for the cash, Tom will only own $3.55 million out of the ne total value.

= 3.55/(3.55 + 1.65)

= 3.55/5.2

40 Hour Week

Cash flow to Tom = EBIT * Tom ownership

= 585,000 * 3.55/5.2

= $399,375

50 Hour Week

= 695,000 * 3.55/5.2

= $474,471.15

b. Under Debt Issue because more cashflow of $546,500 will be due to him.