McKenzie Corporation’s Financial Capital Budgeting

Mckenzie Corporation's Capital Budgeting

Given value of Mckenzie in different scenarios,

Economic Growth

Probability

Without Expansion

With Expansion

Low

$20,000,000

$22,000,000

Normal

$25,000,000

$32,000,000

$43,000,000

$52,000,000

Expected value of the company within one year with Expansion is as follows: =

Formula of E (value of company)

= "P (Low)*V (Low) + P (Normal)*V (Normal) + P (High)*V (High)"

=0.3*22,000,000 +0.5*32,000,000 +0.2*52,000,000

= 6,600,000 + 16,000,000 + 10,400,000

= $33,000,000

= $33 Million.

Expected value of the company within one year without Expansion is as follows:

= P (Low)*V (Low) + P (Normal)*V (Normal) + P (High)*V (High)

= .30*20,000,000 + .50*25,000,000 + .20*43,000,000

=6,000,000 + 12,500,000 + 8,600,000

= $27,100,000

= $27.1 Million.

Answer 2)

Company's debt is $25 million.

Thus, the expected value of the company debt without expansion

= .30*25,000,000 + .50*25,000,000 + .20*25,000,000

= $7,500,000 + $12,500,000 + $5,000,000

= $25 million

Thus, the expected value of the company debt will remain the same which is $25 million with expansion since the company is fully funded by the equity, and debt does not change.

Answer 3)

Expected company value without expansion =$27.1 million

Expected company value with expansion =$ 33 million

Thus, a change in expected value of the company due to expansion

= 33-27.1= $5.9 million

Equity of $ 5.7 million was required to fund the expansion.

Thus, Net Value that is created by expansion

= 5.9 million -- 5.7 million

= $0.2 million

Since the company expansion are entirely financed by the equity, there will be no change in the level of debt. Thus, Expected value for stockholder = $0.2 million

Expected value for bondholders = $0.

Answer 4)

Case 1: Company does not expand:

If the company does not expand, there will be no change in the status of the bondholders since the debt of $25 million remains the same. Thus, there will be no change in the value of the bonds.

Case 2: Company expands:

If the company expands, the expected value of equity holders will rise. Thus, the value of the equity will also increase, which will decrease the debt-equity ratio. Thus, the long-term solvency risk will decrease. It will lead to a low cost of debt, and can be reflected by an increase of the price of bond since the value of the bond will go up.

Answer 5)

If the company decides not to expand, the company does not need to raise fresh capital from equity or debt. Thus, no borrowing is required. If the company decides to expand, it will be challenging to raise debt since the company is under an obligation not to raise further debt until next year. Hence, the company has to finance its entire expansion through equity leading to a rise in the equity base of the Mckenzie. After one year, if necessary, the company can raise debt if it decides to expand. (O'Sullivan, Sheffrin, 2003, Ross, Westerfield, Jafee, 2013).

Answer 6)

If a company decides to finance its expansion with cash, no fresh equity is required. Thus the cost of the fund will be lower and will make the expansion more attractive. The company will record more saving as they can save the floating cost of equity.

Reference

O'Sullivan, A; Sheffrin, S. M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall.

Ross, S.A., Westerfield, R.W., Jafee, J. (2013). Corporate Finance (10 ed). New York. Mcgraw-Hill Irwin.