McKENZIECORPORATIONSCAPITAL

BUDGETING
1.

We assume the $5,900,000 is spent over the course of the year so we can ignore time value of money considerations.
If we include the time value of money, the numerical solutions will change slightly, but the analysis will remain the
same. The expected value of the company in one year without expansion is:
V = .30($25,000,000) + .50($30,000,000) + .20($48,000,000)
V = $32,100,000
And the expected value of the company in one year with expansion is:
V = .30($27,000,000) + .50($37,000,000) + .20($57,000,000)
V = $38,000,000
The companys stockholders appear to be better off with expansion since the expected NPV of the project is positive.
The difference in the expected value of the company with and without expansion is $5,900,000. If the required
investment is $5,700,000, the expansion creates a positive increase in expected value for current shareholders.
However, as further analysis will show, stockholders are actually worse off.

2.

The value of the companys debt with low economic growth is the value of the company because the company value
is less than the face value of the debt. In both other economic states, the value of the debt is the face value of the
debt. So, the expected value of debt in one year without expansion is:
VD = .30($25,000,000) + .50($29,000,000) + .20($29,000,000)
VD = $27,800,000
And the value of the companys debt in one year with expansion is:
VD = .30($27,000,000) + .50($29,000,000) + .20($29,000,000)
VD = $28,400,000

3.

The value of the companys equity with low economic growth is zero both with and without expansion since the
company value will be less than the face value of the debt. The value of equity with normal growth or high growth is
the value of the company minus the $29,000,000 face value of debt. So, the expected value of the equity without
expansion is:
VE = .30($0) + .50($1,000,000) + .20($19,000,000)
VE = $4,300,000
And the value of equity with expansion is:
VE = .30($0) + .50($8,000,000) + .20($28,000,000)
VE = $9,600,000
The value expected for bondholders from the expansion is the difference in the expected value of debt. So, with
expansion, the companys bondholders gain:
Bondholder gain = $28,400,000 27,800,000
Bondholder gain = $600,000
And the value expected for stockholders is:
Stockholder gain = $9,600,000 4,300,000
Stockholder gain = $5,300,000
The stockholder value increases by $5,300,000, but the expansion was funded entirely by equity, so the expected
NPV of expansion for stockholders is actually:
Stockholder NPV = $5,300,000 + 5,700,000
Stockholder NPV = $400,000

4.

Assuming bondholders are fully informed and they act rationally, they will expect the stockholders to act in their best
interest and not expand, so the price of the bonds will not change. If the expansion is announced, the price of the
bonds will increase.

5.

If they dont expand, nothing will happen since it is already priced into the bond. If the company announces the
expansion, they signal they are willing to sacrifice for the bondholders, so the company will receive a lower interest
rate in the future.

6.

It is a stronger signal that stockholders are not acting in their best interest if the expansion is financed with cash on
hand. If the company issues new equity, the expected loss in stock value is shared proportionally by the new
investors, so the current stockholders will not bear the entire loss in stock value alone. By expanding with cash on
hand, current stockholders are bearing the entire expected loss in stock value.