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PROBLEM 1 AGENCY COSTS: Tom Scott is the owner, president, and primary salesperson for Scott Manufacturing. Because of this, the company's profits...

2 problems. one Agency Costs and one Costs of Financial Distress

PROBLEM 1 AGENCY COSTS : 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 $550,000 per year; if he works a 50-hour week, the company's EBIT will be $625,000 per year. The company is currently worth $3.2 million. The company needs a cash infusion of $1.3 million, and it can issue equity or issue debt with an interest rate of 8 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-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? Equity issue Debt issue PROBLEM 2 COSTS OF FINANCE DISTRESS Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of the continuation of the current expansion is 80 percent for the next year, and the probability of a recession is 20 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2.7 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 13 percent. a-1. What is the value today of Steinberg's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32)) Equity Value $__________ Debt Value $__________ a-2. What is the value today of Dietrich's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32)) Equity Value $__________ Debt Value $__________ b. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement? Disagree Agree
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PROBLEM 1 AGENCY COSTS: 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...

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