Mini-Case Study: McKenzie Corporation’s Capital Budgeting


McKenzie Corporation’s Capital Budgeting

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For this paper, your writer had completed this assignment before #112158 but I did not make it in this course as I mentioned in the beginning so I an redoing it. This time please I want you to assigned this paper to a writer who is savvy of the subject matter. It is critical that the writer use critical thinking and carefully read all instructions before beginning to respond to the questions. The writer must clearly respond to all 6 questions and must include all calculations where necessary. The writer must properly format the paper in APA using the 6th edition of APA. where necessary use the appendix and reference it in the discussion. The references must also be in APA double space.

• Mini-Case Study: McKenzie Corporation’s Capital Budgeting

The case study, found on page 557 of your course text, deals with the process of corporate budgeting and the types of decisions that must be made. After reading the scenario:
• Briefly answer the six questions at the end (4 to 6 sentences each).
• Include all calculations you were asked to provide.

SAMPLE ANSWER

Introduction

Capital structure of a company refers to the different combination of debt and equity capital that a company utilizes in a bid to get the most optimal ratio that provides the least weighted average cost of capital. Equity capital can be raised from retained earnings while debt capital can be obtained from external bonds and other long term loans (Ross, Westerfield & Jaffe, 2013).

1).

Economic GrowthProbabilityWithout Expansion Value Without Expansion
Low0.3 $  25,000,000.00 $    7,500,000.00
Normal0.5 $  30,000,000.00 $  15,000,000.00
High0.2 $  48,000,000.00 $    9,600,000.00
Expected value without expansion $  32,100,000.00

 

Economic GrowthProbabilityWithout Expansion Value With Expansion
Low0.3 $  27,000,000.00 $    8,100,000.00
Normal0.5 $  37,000,000.00 $  18,500,000.00
High0.2 $  57,000,000.00 $  11,400,000.00
Gross Expected value with expansion $  38,000,000.00
Less cost of equity $    5,700,000.00
 Expected value with expansion $  32,300,000.00

It would be beneficial for the company to undertake the expansion as it would save $200,000.

2). The expected value of debt after one year with and without expansion would remain the same i.e. $29 million as the expansion would be financed by equity.

3). From the calculations above

Expected value with expansion $  32,300,000.00
Expected value without expansion $  32,100,000.00
Net Value Created $        200,000.00

The value of debt would not be affected hence the bondholders would not benefit from the expansion.

The stockholders would get $200,000 while the bond holders would get nothing from the expansion.

4). Without expansion the price of the bonds would remain unchanged as they would not be affected by the expansion the bondholders status would also remain the same. If the expansion takes place then the ratio of equity would increase and the debt to equity ratio would decrease. The rate of return on company bonds would also decrease. It would then result in an increase in the value of bonds and their prices.

The theory of capital structure by Modigliani and Miller (1958) applies in instances where the investors have similar and homogenous expectation. It also applies where the market is perfect and transactional costs are non-existent. It also applies where Corporation and individual investors can actually borrow or obtain financing at the same rate. The risk-free rate doubles as the cost of debt and it must constant while the company must also  pay all profits in terms of dividend resulting in no growth for the Company.

5). If the company does not expand then its equity would remain the same as the current year. If the bond issue is redeemed and there is no expansion then the company will not be able to get enough equity to get the right financing it may require for its operations.

If the company agrees on the expansion then it will utilize the equity capital to finance it. These actions would create more equity capital for the company (Myers, 1984, pg.16). Hence the capital would be available but according to Modigliani and Miller (1958) the cost of debt to a company is basically cheaper than the cost of equity. Companies experience some kind of savings when they change from equity financing to debt financing. This is mostly in connection with the payment of taxes. Tax advantages are utilized when companies make use of debt capital especially when writing off interest payments. Equity capital application means that the dividends must be paid. Companies in most countries receive government subsidies when using debt to finance capital projects and not when using equity capital (Lopez-Gracia & Sogorb-Mira, 2008, pg. 136)

McKenzie restaurants Inc would be under utilizing its ability to expand due to no-exploitation of its debt portfolio.

6). The company would save as using equity is much more expensive than using debt capital (cash included) Debt capital attracts some benefits in form of waived interest payments and also the cost of changing from equity to cash. The payment by cash for the expansion would be the best alternative for the company.

According to Myers (1984) companies tend to use a pecking order when utilizing capital. The theory asserts that companies prefer financing from internal sources like retained earnings (equity) as compared to external financing for instance from issuance of new common stock. The major reason being that it’s cheaper to use for example retained earnings besides the company does not have to account or disclose the nature of the funding to outsiders like in the case of borrowing from the public where the prospectus is required to reveal all the information regarding the company’s equity and other sources of funds. Most companies will issue debt first even before issuing common stock incase external financing is unnecessary. When common stock is issued it sends a signal to the shareholders and other prospective investors that something needs to fixed urgently and it may not be positive for the company. However, the ratio of debt to equity depends on other factors in the real world such as the state of the economy, prevailing market interest rates and the urgency of the debt or equity.

References

Lopez-Gracia, J., & Sogorb-Mira, F. (2008). Testing trade-off and pecking order theories financing SMEs. Small Business Economics, 31, 117-136. Doi:10.1007/s11187-007-9088-4

https://econpapers.repec.org/scripts/redir.pf?u=http%3A%2F%2Fhdl.handle.net%2F10.1007%2Fs11187-007-9088-4;h=repec:kap:sbusec:v:31:y:2008:i:2:p:117-136

Modigliani, F. and Miller, M. (1958) “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review, June, 48:3, 261–97.

Myers, S. (1984)”The Search for Optimal Capital Structure,” Midland Corporate Finance Journal, 1 spring, 6-16

Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013). Corporate finance (10thed.). New York:  McGraw-Hill Irwin

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