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 $409,000 per year; if he works a 50-hour week, the company's EBIT will be $509,000 per year. The company is currently worth $2.52 million. The company needs a cash infusion of $1.36 million, and it can issue equity or issue debt with an interest rate of 9.8 percent. Assume there are no corporate taxes.
Question # 1:
What are the cash flows to Tom under each scenario? Round your answers to the nearest whole dollar amount. (e.g., 32)
Debt issue Equity issue
40 hour week cash flow $ $
50 hour week cash flow $ $
Under which form of financing is Tom likely to work harder? Debt issue or Equity issue?
This solution illustrates the margin effect on cash flows of increasing one's earnings before interest and taxes, as well as the effect of issuing equity versus debt.