Tom Scott is the owner, president, and primary salesperson for Scott Manufacturi

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 $645,000 per year; if he works a 50-hour week, the company's EBIT will be $815,000 per year. The company is currently worth $4.15 million. The company needs a cash infusion of $2.25 million, and it can issue equity or issue debt with an interest rate of 9 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 and round your answers to the nearest whole number, e.g., 32.) Scenario-1 Debt issue: Cash flows 40-hour week $ 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? Debt issue Equity issue

Explanation / Answer

Scenario 1

For debt issue

If he works 40 hours

then EBIT = $ 645,000

Interest =9% * 2.25 M = $ 202,500

PAT( Net Income) = 645,000-202,500= 442,500 which goes to Tom

ROE for Tom = 442,500/4.15 M = 10.66%

If he works , 50 Hours

then EBIT = $ 815,000

Interest = 202,500

PAT(Net Income) = 612,500

ROE = 612,500/4.15 = 14.75%

Scenario 2

For Equity infusion, Tom will have to infuse addtional equity which means total equity =4.15+ 2.25 = 6.4 Million

For 40 hour week, EBIT= 645,000= Net Income = Cash flows to Tom

ROE = 645,000/6.4 = 10.07%

For 50 hour week, EBIT =$ 815,000

ROE = 815,000/6.4 = 12.73%

As ROE under debt financing is higher for Tom, he will likely work harder under debt financing.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.