Question Three

Kofi Manu is the owner, managing director, and primary salesperson for Manu Manufacturing Ltd. Because of this, the companys profits are driven by the amount of work Kofi does. If he works 40 hours each week, the companys EBIT will be GHC 4,000,000 per year; if he works a 50-hour week, the companys EBIT will be GHC 5,000,000 per year. The company is currently worth GHC 2.5 million. The company needs a cash infusion of GHC1.2 million. It can issue equity to new shareholders or issue debt at an interest rate of 24 percent. Assume the corporate tax rate is 25% and the personal tax rate for Kofi is 20%.

(a). What are the cash flows to Kofi under each scenario? That is, issue equity and work 40 hour-week; issue equity and work 50 hour-week; issue debt and work 40 hour-week and issue debt work 50 hour-week.

(b). Under which form of financing is Kofi likely to work the longer hours? Explain briefly.

(c). Explain why issuing equity would result in agency relationship, whereas issuing debt will not.

(d). The agency relationship will be between whom and whom?