Tom Scott is the owner, president, and primary salesperson for Scott Manufacturi
ID: 2737956 • 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 $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.