Mary owns 100 percent of a gift shop with an equity value of $150,000.If she keeps the shop open 5 days a week,EBIT is $75,000.If the shop remains open 6 days a week,EBIT increases to $92,000 annually.Mary needs an additional $50,000 which she can raise today by either selling stock or issuing debt at an interest rate of 7 percent.The principal amount would be repaid in equal annual payments at the end of the next five years.Ignore taxes.What will be the cash flow for the year to Mary if she issues debt,remains open 5 days a week,and distributes all the residual cash flow to the shareholders?
A)$46,125
B)$61,500
C)$65,000
D)$71,500
E)$67,880

Question

Quizplus · Accepted Answer

If Mary issues debt, she would have an additional $50,000 to invest in the business, which would increase her EBIT to $92,000 if the shop remains open 6 days a week. However, she decides to keep the shop open 5 days a week and distribute all the residual cash flow to the shareholders.

The first step is to calculate the interest payment on the debt, which is $50,000 * 7% = $3,500. The principal payment would be $50,000/5 = $10,000 per year.

With the shop open 5 days a week, the EBIT is $75,000. After deducting the interest payment of $3,500 and the principal payment of $10,000, the cash flow to Mary would be $61,500 ($75,000 - $3,500 - $10,000 = $61,500).

Therefore, the best choice is B.

Mary Owns 100 Percent of a Gift Shop with an Equity