McKenzie Corporations Capital Budgeting - Assignment Example

Case McKenzie Corporation‘s Capital Budgeting Introduction It is of immense importance that one gets the knowledge on the market as well as comprehends the nature of the economy. This comprises the current as well as the future of the economy for a good understanding of the company’s financial success. The most prominent financial decision for managers is the capital budgeting decisions. These decisions are of the essence as they affect the success of the firms. Evaluation of the capital budgeting decisions comprises the determination of the value of debts as well as the stockholders position (Ross, 390). These values include the debts as well as value of stockholders in relation to expansion and non-expansion. The value created in the case of expansion is calculated to estimate the new share of the stockholders, as well as bondholder. The calculations below are the estimate of the needs for the company in regards to its future borrowing with and without expansion. Question 1 Economic Growth Probability Without Expansion With Expansion? Low .30 $30,000,000 $33,000,000? Normal .50 $35,000,000 $46,000,000? High .20 $51,000,000 $64,000,000 Expected value of the company without expansion =E (value of company) =P (Low)*V (Low) +P (Normal)*V (Normal) + P (High)*V (High) =0.3*30 +0.5*35 + 0.2*51 = $36.7 million Expected value of the company with expansion =E (value of company) =P (Low)*V (Low) + P (Normal)*V (Normal) +P (High)*V (High) =0.30*33 + 0.50*46 + 0.20*64 = $ 45.7 million Based on the calculated values the stockholders are better off with an expansion in the company. This is because the value is higher by $9 million that implies that the firm's value, as well as the profits, would increase. Question 2 Debt of Company - $34 million Expected value of debt without the expansion = 0.30*34 + 0.50*34 + 0.20*34 = $34 million. The expansion is fully financed by equity this implies that the debt does not change. Therefore, the value of expected debt will remain the same with no changes. Question 3 Expected value of the company without expansion =E (value of company) =P (Low)*V (Low) +P (Normal)*V (Normal) + P (High)*V (High) =0.3*30 +0.5*35 + 0.2*51 = $36.7 million Expected value of the company with expansion =E (value of company) =P (Low)*V (Low) + P (Normal)*V (Normal) +P (High)*V (High) - Cost of financing = .30*33 + .50*46 + .20*64 -8.4 = $ 37.3 million The value of debt remains the same this implies that the additional value would be for the stockholders. The value expected for the stockholders = 0.6 million while the expected value for the bondholders =0. Change in the expected net Value due to the expansion =37.3 - 36.7= 0.6 million Question 4 An expansion of the company there will lead to a decrease in debt to equity ratio as well as long-term risk of the company. This is because the equity of the company will rise. The bond value, as well as the price of bonds for the company, will increase. This will also be accompanied by an increase in the profits to both stockholders as well as bondholders of the company (Ross, 390). Without an expansion, the value of bonds in the company will not change. The status of the bondholders remains unchanged, as well. The value of the debt remains as $34 million. Question 5 Without expansion, the equity of the company remains the same in the next year as in the current year. This is since additional capital will not be necessary if there is no expansion. Debt is, therefore, not of the essence in both the present and the future the company as it will not be able to borrow (Ross, 390). This will be in the case where the company continues to decrease their current debt. The company will not have greater equity in the next year once the debt covenants are over. This implies that the company will not access the financing it needs to expand. If the company expands, it will not be able to raise the debt. This is because they are prohibited from issuing any additional borrowing. They would then need to do the expansion by means of equity financing. The expansion would create an increase in equity of the company. This increase in financing is because of more financing after the next year due to implemented debt covenants. This assists in the borrowing needs in the future. Question 6 If the expansion had been financed through cash in hand, it would have been enhanced. This is because the company would not incur any additional costs (Ross, 390). These costs would include the expenses incurred in changing equity into cash in the form of fees and expenses. Financing the company through cash instead of equity implies that there would be no need for new equity. If the expansion were financed with cash, rather than equity no new equity would be needed. Thus, the cost of expansion would be lower in the case of cash, in hand. Case 2 Stephenson Real Estate Recapitalization Question 1 To increase the overall value of the firm, Stephenson uses debt for financing. This is the $60 million debt in purchases. Interest rate is tax deductible thus, payments of the debt will decrease the firms’ taxable income. This will affect the capital structure by creating a tax shield that increases the value of the firm. The issuance of debt creates a tax shield. This causes a decline in tax payables as well as the entire value of the firm. Question 2 Stephenson is an all-equity firm that comprises of 20 million shares in outstanding common stock with a value of $35.50 for every share (Ross, 390). This give a total of (20* 35.50= $710 million). This estimate would be utilized in the construction of Stephenson’s market-value balance sheet before the land purchase was announced. Market Value Balance Sheet in million’s in millions Assets 710 Equity 710 Total assets 710 Debt & Equity 710 Question 3 a. Stephenson’s pre- tax earnings will increase by $14 million because of the purchase in perpetuity annually. These earnings are subjected to a 40% tax rate. This implies that the purchase causes an increase in the expected earnings per year by $8.4 million. This is calculated as shown below; {($14) (1-0.40)} = $8.4 million The unlevered cost of equity capital for the firm (r0), which is 12.5%, is used. This is because Stephenson is an all-equity firm. NPV (Purchase) = - $60,000,000 + {($14,000,000) (1 – 0.40) / 0.125} = - $60,000,000 + ($8.4 million / 0.125) = $7,200,000 This implies that the net present value for the purchase of land is $7.2 million b. The value of Stephenson will go up to $7.2 after the announcement. This increase is the representation of the net present value of the purchase (Ross, 390). Under an efficient market hypothesis, market value of the Stephenson equity will increase immediately. This immediate increase is the reflection of the NPV of the project. The market value for the firm will, therefore, be $717.2 million ($710 +$7.2) after the firm has made the announcement. After the announcement, the balance sheet of the firm would be represented as shown below; Market value balance sheet In millions in millions Old Assets 710 NPV of project 7.2 Equity 717.2 Total assets $717.2 Debt & Equity $717.2 The new market value for Stephenson equity is $717.2 million. Since Stephenson has 20 million shares in outstanding common stock, its price of stock after the announcement will be ($ 717.2 million/ 20 million shares) = $35.86 per share. To finance the purchase, Stephenson must increase the $ 60 million. Since the firm’s stock is $35.86 per share, it needs to issue ($60/$35.86 per share) = 1.67 shares to finance the initial outlay for the purchase. c. As a result of the equity issue Stephenson will receive $60 million (=1,673,173 shares * $35.86 per share) in cash (Ross, 390). This will result in a rise in the firm’s assets and equity by $60 million. Market value balance sheet In millions in millions Cash $60 Old assets $710 NPV of project $7.2 Equity $777.2 Total Assets $777.2 Debt & Equity 777.2 Stephenson issued 1,673,173 to finance the purchase this implies it has 21,673,173 (20 + 1.6) million shares outstanding after the equity issue. The market value of the firm’s equity is $777.2 million, and the firm has 21.673 shares of common stock outstanding. The stock price after equity issue will be (777.2/ 21.673 million shares) = 35.86. The price remains the same per share. d. Additional annual pre-tax earnings generated from the project are $14 million. The earning is subject to a 40% tax. Thus, annual increase after tax is {($14 million) (1- 0.40)} = $ 8.4 million. A perpetuity making annual payments of $8.4 million, discounted at 12.5% is equal to the present value of these cash flows. Pv Project = $14 million / 0.125 = $112 million Market value balance sheet In millions in millions Old assets $710 PV of project $ 112 Equity $822 Total asset $822 Debt & Equity $822 Question 4 With corporate taxes, Modigliani-Miller Proposition I states that; VL = VU + TCB Where VL = levered firm value VU = unlevered firm value TC = rate of corporate tax B = debt in a firm’s capital structure Stephenson is worth $ 822 million if it is financed by purchase of equity. If financed by debt, the firm would have $ 110 million worth of 8% debt outstanding. Thus: VU = $822 million TC = 0.40 B = $60 million Financing through debt gives the market value as; VL = VU + TCB = $822 million + (0.40) ($60 million) = $ 846 million b. Upon announcement, value of Stephenson will increase by the PV of the project. With the market value of the firm's debt being $60 million and the value of the firm as $846, the market value of Stephenson’s equity must be $786 million (=$ 846- $60 million). Stephenson’s market-value balance sheet after the debt issue is: Market value balance sheet In millions in millions Value unlevered $822 Debt $60 Tax shield $24 Equity $786 Total assets $846 Debt & Equity $846 Stephenson has equity of $786 million and 20 million shares in outstanding common stock. Therefore, stock price after debt issue will be $39.3 per share ($786/20 million shares). =$ 39.3 per share. Question 5 If Stephenson finances the project using the equity, the stock price of the firm will remain at $35.86 for every share. On the other hand, if it finances the project using debt the stock price of the firm will rise to $39.3 for every share. Work Cited Ross, Stephen A. Corporate Finance: Core Principles & Applications. Boston: McGraw-Hill/Irwin, 2007. Print. Read More