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Homework answers / question archive / Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing
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 $620,000 per year, and if he works a 50-hour week, the company's EBIT will be $765,000 per year. The company is currently worth $3.90 million. The company needs a cash infusion of $2.00 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? (Do not round intermediate a. calculations and enter your answers in dollars, not millions of dollars, rounded to the nearest whole dollar, e.g., 1,234,567.) b. Under which form of financing is Tom likely to work harder? a. Debt issue and 40-hour week Debt issue and 50-hour week Equity issue and 40-hour week Equity issue and 50-hour week Will work harder with b.
Answer : (a.) Calculation of Cash Flow under each scenerio :
Under Debt Issue working for 40-hour week :
In case of Debt , the amount of
Interest = Debt * Interest Rate
= 2,000,000 * 0.08
= 160,000
Cash Flow Under Debt Issue working for 40-hour week = 620000 - 160000 = 460000
Cash Flow Under Debt Issue working for 40-hour week =765000 - 160000 = 605000
Under Equity issue
% of ownership of Tom Scott = 3,900,000 / (3,900,000 + 2,000,000)
= 0.6610 or 66.10%
Cash Flow in case of 40-week = 620000 * 0.6610 = 409831
Cash Flow in case of 50-week = 765000 * 0.6610 = 505698
(b.) Since the cash Flow under Debt Financing is higher due to fixed payment to debtholders without dilution of ownership in equity interest, therefore Tom will work harder under Debt Option.
