Problem 15-2 Agency Costs Tom Scott is the owner, president, and primary salespe
ID: 2657370 • Letter: P
Question
Problem 15-2 Agency Costs
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 $625,000 per year; if he works a 50-hour week, the company's EBIT will be $775,000 per year. The company is currently worth $3.95 million. The company needs a cash infusion of $2.05 million, and it can issue equity or issue debt with an interest rate of 9 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:
Scenario-2
Equity issue:
b. Under which form of financing is Tom likely to work harder?
Debt issue
Equity issue
Cash flows 40-hour week $ 50-hour week $Explanation / Answer
a Debt Issue The company needs a cash infusion of $ 2.05 million. In case of debt,company will have to make interest payments Interest = 2.05*1000000*9% Interest 184500 Cash flow to Tom would be EBIT Less Interest 40- hour week EBIT 625000 Less: Interest -184500 Cash flow 440500 50 - hour week EBIT 775000 Less: Interest -184500 Cash flow 590500 b Equity Issue If the company issues Equity, the company value will increase by the amount of issue. So, the current owner's equity interest in the company will decrease to Tom's ownership percentage 3950000/(3950000+2050000) Tom's ownership percentage 0.658333333 So Tom's cash flow under an equity issue will be 65.83% of EBIT 40-hour week cash flow 625000*65.83% 411458.3333 50-hour week cash flow 775000*65.83% 510208.3333 c Tom will work harder under debt issue since the cash flow from debt issue would be higher than that of equity issue