18 Agency Costs Tom Scott is the owner, chairman 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 profit before interest and taxes will be £500,000 per year; if he works a 50-hour week, the company’s profit before interest and taxes will be £600,000 per year. The company is currently worth £3 million. It needs a cash infusion of £2 million, and it can issue equity or issue debt with an interest rate of 9 per cent. Assume there are 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?