James M. Jones Jr. is an entrepreneur and the founder of Tasty Cakes Bakery. During the last year, Tasty Cakes generated $40,000 in operating cash flows, paid $10,000 in capital expenditures (as he does almost every year), and paid $5,000 in dividends. Jones is interested in significantly expanding this year. To do so, he needs to spend $100,000 on equipment in addition to his normal capital expenditures. He believes that if he buys the equipment, his operating cash flows will surely increase by 25% and possibly could double. He has spoken with the bank, which has offered the following two installment note options where an equal amount of principal is due each year:
Option 1: Two-year, 5%, $100,000 installment note
Option 2: Six-year, 10%, $100,000 installment note
a. Calculate Tasty Cake's free cash flow.
b. Identify the advantages and disadvantages of each option the bank provides.
c. Which option should Jones choose and why?

  • CreatedJuly 16, 2015
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