Tom Scott is the owner, president, and primary salesperson for Scott Manufacturi

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 $575,000 per year; if he works a 50-hour week, the company's EBIT will be $675,000 per year. The company is currently worth $3.45 million. The company needs a cash infusion of $1.55 million, and it can issue equity or issue debt with an interest rate of 7 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.) Scenario-1 Debt issue: Cash flows 40-hour week $ 550000 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 Debt issue

Explanation / Answer

a.

Scenario 1: Debt issue

Cash infusion required = $1,550,000

Interest expense = $1,550,000 * 7% = $108,500

Cash flows to Tom = EBIT – Interest

40 hours each week; Cash flow to Tom = $575,000 - $108,500 = $466,500

50 hours each week; Cash flow to Tom = $675,000 - $108,500 = $566,500

Scenario 2: Equity issue

Issuing equity will dilute the ownership of Tom.

Current value of Tom’s share = $3,450,000

Value of company after issuing equity = $3,450,000 + $1,550,000 = $5,000,000

Tom’s percentage share = $3,450,000 / $5,000,000 = 69%

Cash flows to Tom = EBIT * Share in ownership

40 hours each week; Cash flow to Tom = $575,000 * 69% = $396,750

50 hours each week; Cash flow to Tom = $675,000 * 69% = $465,750

b.

Under equity form of financing, Tom is likely to work harder because for every increase in EBIT Tom will get only 69% of the increase. In case of Debt form of financing, Tom will receive the full amount of increase in EBIT.

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