Question

Sean Davis is the owner, president, and primary salesperson for Davis Manufacturing. Because of this, the company's profits are driven by the amount of work Sean does. If he works 40 hours each week, the company's EBIT will be $594,000 per year; if he works a 50-hour week, the company's EBIT will be $762,000 per year. The company is currently worth $3.5 million. The company needs a cash infusion of $1.7 million, and it can issue new equity or issue debt with an interest rate of 10%. Assume there are no corporate taxes. What are the cash flows to Sean if he works a 40-hour week and debt is issued for the cash infusion? (Round answer to 0 decimal places. Do not round intermediate calculations) What are the cash flows to Sean if he works a 50-hour week and debt is issued for the cash infusion? (Round answer to 0 decimal places. Do not round intermediate calculations) What are the cash flows to Sean if he works a 40-hour week and equity is issued for the cash infusion? (Round answer to 0 decimal places. Do not round intermediate calculations) What are the cash flows to Sean if he works a 50-hour week and equity is issued for the cash infusion? (Round answer to 0 decimal places. Do not round intermediate calculations)

Answer 1

Answer:

The related cash flows to Sean are as follows;

a. $424,000

b. $592,000

c.$399,808

d. $512,885

Explanation:

In this question, we are asked to calculate cash flows to Davis manufacturing given that debt is issues and equity is issued for a number of hour-week

We proceed as follows;

a. For a 40 - hour week and Debt is issued

Mathematically, the cash flow is calculated below as follows;

Cash Flow = EBIT - Interest on debt = $594,000 - ($1.7 million x 10%) = $424,000

b. For a 50 - hour week and Debt is issued

Mathematically, the cash flow is calculated as follows;

Cash Flow = EBIT - Interest on debt = $762,000 - ($1.7 million x 10%) = $592,000

c. For a 40 - hour week and Equity is issued

Mathematically, the cash flow is calculated as follows;

In this case, there will be no interest cost

The firm's value will be increased by the amount of infusion but ownership of sean will be diluted.

New ownership of Sean = $3.5 million / ($3.5 million + $1.7 million) = 0.67307692307

Mathematically, the cash flow is calculated as follows

Cash Flow to Sean = EBIT x new share = $594,000 x 0.67307692307 =  $399,808

d. For a 50 - hour week and Equity is issued

The calculation is as above and there is also no interest course

Cash Flow = EBIT x new share = $762,000 x 0.67307692307 =  $512,885

KINDLY NOTE EBIT IS EARNINGS BEFORE INTEREST AND TAXES