Tom Scott is the owner, president, and primary salesperson for Scott Manufacturi
ID: 2657784 • Letter: T
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 $600,000 per year, if he works a 50-hour week, the company's EBIT will be $725,000 per year. The company is currently worth $3.7 million. The company needs a cash infusion of $1.8 million, and it 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? Equity issue ODebt issueExplanation / Answer
Answer to Part a.
Scenario – 1: Debt Issue
40- Hour Week Cash Flow = $600,000 – [$1,800,000 * 8%]
40- Hour Week Cash Flow = $600,000 - $144,000
40- Hour Week Cash Flow = $456,000
50- Hour Week Cash Flow = $725,000 – [$1,800,000 * 8%]
50- Hour Week Cash Flow = $725,000 - $144,000
50- Hour Week Cash Flow = $581,000
Scenario – 2: Equity Issue
Tom’s Proposed Proportion in Equity = 3,700,000 / (3,700,000 + 1,800,000)
Tom’s Proposed Proportion in Equity = 3,700,000 / 5,500,000
Tom’s Proposed Proportion in Equity = 0.6727
40- Hour Week Cash Flow = $600,000 * 0.6727
40- Hour Week Cash Flow = $403,620
50- Hour Week Cash Flow = $725,000 * 0.6727
50- Hour Week Cash Flow = $487,708
Answer to Part b.
Tom is more likely to work harder under Debt issue scenario, as it will retain full ownership.
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