Corporate Finance Chapter 17 Mini Case

Chapter 17

McKENZIE CORPORATION’S CAPITAL BUDGETING

1. What is the expected value of the company in one year, with and without expansion? Would the company’s stockholders be better off with or without expansion? Why?  

The expected value of the company in one year without expansion is:

V1 = .30($25,000,000) + .50($30,000,000) + .20($48,000,000) = $32,100,000

The expected value of the company in one year with expansion is:

V2 = .30($27,000,000) + .50($37,000,000) + .20($57,000,000) = $38,000,000

The difference between V2 and V1 is:

$38,000,000 - $32,100,000 = $5,900,000

Since the expansion will be entirely financed with equity at a cost of $5,700,000 which is less than $5,900,000, the expansion will create a positive value for the shareholders. So the stockholders may be better off with expansion.

2. What is the expected value of the company’s debt in one year, with and without the expansion?

The expected value of the company’s debt in one year without expansion is:

VD1 = .30($25,000,000) + .50($29,000,000) + .20($29,000,000) = $27,800,000

The expected value of the company’s debt in one year with expansion is:

VD2 = .30($27,000,000) + .50($29,000,000) + .20($29,000,000) = $28,400,000

3. One year from now, how much value creation is expected from the expansion? How much value is expected for stockholders? Bondholders?  

Value creation expected from the expansion is:

V2 - V1 = $38,000,000 - $32,100,000 = $5,900,000

Bondholders gain: VD2 - VD1 = $28,400,000 - $27,800,000 = $600,000

Stockholders gain: (V2 - VD2) – (V1 - VD1) = $5,900,000 - $600,000 = $5,300,000