Tom Scott is the owner, president, and primary salesperson for Scott Manufacturi
ID: 2783203 • 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 $640,000 per year; if he works a 50-hour week, the company's EBIT will be $805,000 per year. The company is currently worth $4.1 million. The company needs a cash infusion of $2.2 million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume there are no corporate taxes.
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.)
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 $640,000 per year; if he works a 50-hour week, the company's EBIT will be $805,000 per year. The company is currently worth $4.1 million. The company needs a cash infusion of $2.2 million, and it can issue equity or issue debt with an interest rate of 8 percent. Assume there are no corporate taxes.
Explanation / Answer
Answer to Part a)
Scenario 1 – Debt Issue:
The Company issues Debt to meet requirement of $2.2 Million
Interest Expense = $2,200,000 * 8%
Interest Expense = $176,000
Cash Flow to Owner = EBIT – Interest
40-Hour Week:
Cash Flow = $640,000 - $176,000
Cash Flow = $464,000
50-Hour Week:
Cash Flow = $805,000 - $176,000
Cash Flow = $629,000
Scenario 1 – Equity Issue:
The Company issuing Equity to meet the requirement will change the Company and which inturn will change Ownership percentage.
Company Value = $4,100,000 + $2,200,000 =$6,300,000
Ownership Percentage = 4,100,000 / 6,300,000 = 65.08%
Cash Flow under Equity Issue = 65.08% of EBIT
40-Hour Week:
Cash Flow = $640,000 * 65.08%
Cash Flow = $416,512
50-Hour Week:
Cash Flow = $805,000 *65.08%
Cash Flow = $523,894
Answer to Part b)
Debt issue form of Financing will work harder for Tom, as it will provide Higher EBIT to Tom as compared to Equity Issue.