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 $635,000 per year; if he works a 50 hour week, the company's EBIT will be $795,000 per year. The company is currently worth $4.05 million. The company needs a cash infusion of $2.15 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 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-1Debt issue: Cash flows 40-hour week $ 50-hour week $ Scenario-2Equity issue: Cash flows 40-hour week $ 50-hour week $ b. Under which form of financing is Tom likely to work harder?Debt issueEquity issue

Answer 1

Answer:

The computation is shown below:

Explanation:

The computation is shown below:

a. In the first case i.e Debt issue which is

= EBIT - interest expense

where,

Interest expense is

= $2,150,000 × 7%

= $150,500

So for 40 hours, it would be

= $635,000 - $150,500

= $484,500

And, for 50 hours, it would be

= $795,000 - $150,500

= $644,500

In the second case i.e equity issue which is

= EBIT × ownership interest

where,

ownership interest is

= $4,050,000 ÷ ($4,050,000 + $2,150,000)

= 65.32%

So for 40 hours week, it would be

= $635,000 × 65.32%

= $414,782

And, for 50 hours week, it would be

= $795,000 × 65.32%

= $519,284

b. So, the tom would likely to work harder in Debt issue