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CHAPTER 17 C-1
CHAPTER 17
McKENZIE CORPORATION’S CAPITAL
BUDGETING
1. We assume the $5,700,000 is spent immediately 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:
And the expected value of the company in one year with expansion is:
The company’s 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
2. The value of the company’s 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:
And the value of the company’s debt in one year with expansion is:
3. The value of the company’s 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 $25,000,000 face value of
debt. So, the expected value of the equity without expansion is:
And the value of equity with expansion is:
CHAPTER 17 C-2
The value expected for bondholders from the expansion is the difference in the expected value of
debt. So, with expansion, the company’s bondholders gain:
And the value expected for stockholders is:
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:
4. Assuming bondholders are fully informed and they act rationally, they will expect the stockholders
5. If they don’t expand, nothing will happen since it is already priced into the bond. If the company
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
