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 a week, the company's EBIT is $450,000 and if he works 50 hour weeks, company EBIT is $550,000 per year. Company is currently worth $2.7 million. Company needs a cash infusion of $1.5 million and it can issue equity or debt with an interest rate of 9%. Assume for this problem no corporate taxes.
a. What are the cash flows to Tom under each scenario?
B. Under which form of financing is Tom likely to work harder?
c. What specific new costs will occur with each form of financing?
Given two profit scenarios with different amounts of debt and equity financing, this solution discusses which will result in the greater cash flows, what costs are unique to each, and which will cause the owner to work harder to earn cash.