Capital Budgeting - Case Study Example

Introduction Investment decisions are synonymous to capital budgeting decisions (Peterson, 2000). Capital budgeting is a complex issue prone to past and future liquidity issues. Many expansion plans by corporations usually necessitate the mobilization of funds either from external sources or within the company. Either of these decisions have profound impact on the operational ability of the firm. External debt in particular may suffer from the influence of outstanding external debt, which may limit the amounts and nature of funding a company can add to its total credit.

This latter situations describe the state of affairs at McKenzie Corporation, where the company’s ability to raise outside debt is barred by conditions imposed on the company for a prior $14 million bond issue by the company. Consequently, the company has to rely solely on equity, which will incur the company $1.4 million. This report evaluates the company with regard to different economic climates. Expected Value of the Company The table below shows the value of the company without expansion and with expansion given the expected economic situations expected next year.

Economic Growth EV (Without Expansion) EV (With Expansion) Low $3,300,000 $3,900,000 Normal $8,750,000 $12,000,000 High $4,500,000 $5,700,000 Total Value $16,550,000 $21,600,000 The expected value of the company without any expansion is $16,550,000, while the value of the company with expansion is $21,600,000. Clearly, the company will report a better valuation with the expansion than without the expansion. Consequently, the company’s investors would fare better with the expansion as the value of their investment in the company would be more than $5,050,000.

A positive cash flow is an indication of a viable business venture (Docsity, 2011). Expected Value of the Company’s Debt, with and without Expansion The only thing that would increase a company’s debt obligation would be the acquisition of further debt obligations. The value of the debt would remain at the same value of $1.4 million, since the expansion would be funded by using equity and not debt. However, the debt will be reduced by $14 million next year, since the bond gets mature and paid off by the company.

Value Creation Expected from the Expansion The expansion of the company will increase the value of the company. However, the move will also incur additional capital expenses that require further adjustment (Drake, 2007) from the total value of the company after expansion in order to obtain the real value created by the expansion. Expected value without the expansion: $16,550,000 Expected value with the expansion: $21,600,000 Value of financing using equity: $4,500,000 Value with the expansion: $21,600,000 – $4,500,000 = $17,100,000 Therefore, the net value created for the shareholders from expanding will be $17,100,000 - $16,550,000 = $550,000.

The bond value would remain constant; therefore, the value creation for the bondholders will be $0. Price of the Bonds If the Company Announces That It Will Not Expand If the company does not expand, the price of the bonds will remain as it stands this year. The bondholders will receive the same amount of cash as before. If the company expands, however, the company’