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? (Ross, Westerfield, Jaffe, & Jordan, 2011) Without Expansion | 0. 3 * 11,000,000| = 3,300,000| 0. 5 * 17,500,000| = 8,750,000| 0. 2 * 22,500,000| = 4,500,000| Total | 16,550,000| With Expansion | 0. 3 * 13. 000,000| =39,000,000| 0. 5 * 24,000,000| =12,000,000| 0. 2 * 28,500,000| =5,700,000| Total | 56,700,000| The company would be better off with the expansion, because no matter what economic state the company may be in they will add value.
In fact the company stands to gain significant value, regardless of the economic state. 2. What is the expected value of the company’s debt in one year, with and without the expansion? .3*14=4. 2 low . 5*14=2. 8 Normal . 2*14=2. 8 High (million dollars) 4. 2+7+2. 8= $14 million of debt 3. One year from now, how much value creation is expected from the expansion? How much value is expected for stockholders? Bondholders? Value Created from Expansion | Difference from company values of expanding and not expanding (56,700,000-16,550,000)| 40,150,000| Minus the equity | 4,500,000| Value expected for Stockholders| 35,650,000|
Value expected for Bondholders| 0| There is no value expected for the current bondholders because the project is going to be funded by equity. 4. If the company announces that it is not expanding, what do you think will happen to the price of its bonds? What will happen to the price of the bonds if the company does expand? Nothing will happen to the price of the bonds because they will remain the same because there is no added debt. If the company does expand equity will increase which will decrease the debt equity ratio, long term solvency risk will decrease. Resulting in low cost of debt and it could increase the value of bonds.
Also since the bonds are almost due, an increase in bond value can help the company sell the bonds at a premium in the future. This can make it that once the bond holders year is up, they may reinvest in bonds because they will be worth more, making future bond sales better if the company needed to do so. 5. If the company opts not to expand, what are the implications for the company’s future borrowing needs? What are the implications if the company does expand? If the company does not expand, it is not going to hurt the company because they are not going to borrow any more money.
The option to not expand is not a bad thing; just expanding is a better option. If the company does expand they cannot raise debt, and the expansion is going to be paid for by equity. At the end of the year the company can add more debt because the bonds will be paid, and the company will be in a position where they can add more debt if they need to. This option does not have negative implications. 6. Because of the bond covenant, the expansion would have to be financed with equity. How would it affect your answer if the expansion were financed with cash on hand instead of new equity?
The company would not be using fresh equity, they would be using equity delegated for the expansion which makes the cost to fund lower because they are not having to pay dividends to new stockholders. They are saving their floating equity, but their future equity will be less so it almost equals out, minus not having to pay dividends to new stockholders for new equity. References Ross, S. , Westerfield, R. , Jaffe, J. , & Jordan, B. (2011). Corporate Finance: Core Principles and Applications (3rd ed. ). Boston: McGraw-Hill Irwin. ISBN: 978-0-07-353068-0.