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 $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 it 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? (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 420000 50-hour week 535000 Scenario-2 Equity issue Cash flows 40-hour week 50-hour week b. Under which form of financing is Tom likely to work harder? Debt issue Equity issue

Explanation / Answer

Scenerio 1

Scenerio 2 : Equity Financing

In case of equity Financing, there is no fixed charge unlike debt. However the proceeds shall be shared in the ratio of equity. Post capital infusion, Tom owned 3.6 Million out of the firm which has value (3.6+1.7Million $).

Thus Tom will get (1.7/ (3.6+1.7) )% or 67.9245% of the cash proceeds in case he opts for the equity way of financing.

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b. Tom is more likely to work hard if he opts for debt financing.
The logic is very simple. In case of debt financing, he shall be able to enjoy the fruits of profit along after the fixed charge as the entire surplus net of interest is attributable to him. However in case he opts for equity financing he shall have to share out of every extra $ made.

40 Hour week 50 Hour Week Total Cash flow 590000 705000 Less : Interest 170000 170000 Net Cashflow attributable to Tom 420000 535000

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