Tom Scott is the owner, president, and primary salesperson for Scott Manufacturi
ID: 2733340 • 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 $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 $3.60 million. The company needs a cash infusion of $1.70 million, and it can issue equity or issue debt with an interest rate of 10 percent. Assume there are no corporate taxes.
What are the cash flows to Tom under each scenario? (Enter your answers in whole dollars, not millions of dollars. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))
a. This section is correct
Debt Issue :
The company needs a cash infusion of 1.70 Million. If the company issues debt, the annual interest payment will be :
Interest = 1,700,000 * 10% = $170,000
The cash flow to the owner will be the EBIT minus the interest payments, or :
40-Hour week cash flow = 590,000 – 170,000 = $420,000
50-Hour week cash flow = 705,000 – 170,000 = $535,000
Equity Issue : This section is incorrect. Help please!!
If the company issues equity, the company value will increase by 1.70 Million. So, the current owner’s equity interest in the company will decrease to :
Tom’s Ownership percentage = 3,600,000 / (3,600,000 + 1,700,000) = 0.68
So, Tom’s cash flow under an equity issue will be 68% of EBIT, or :
40-Hour week cash flow = 590,000 * 68% = $401,200
50-Hour week cash flow = 705,000 * 68% = $479,400
a.What are the cash flows to Tom under each scenario? (Enter your answers in whole dollars, not millions of dollars. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))
Scenario-1 Debt issue:Explanation / Answer
Company worth is $3.60 Million. Worth means excess of assets over liabilities. By issuing the equity shares the liability increases and the net worth decrease. New Net worth will become $3.60m - $1.70m = 1.90 Millon
% decrease in net woth = 47.22 %
There is no change in the cash flows ass equity issue has no impact on income statement.