Mackenzie capital budget analysis.- chapter 17 capital structure 557

 

Chapter 17

Capital Structure

557

www.mhhe.com/rwj

remain unlevered forever. If OPC does not retire the debt, the company will use the

$2.5 million in cash to buy back some of its stock on the open market. Repurchasing

stock also has no transaction costs. The company will generate $1,300,000 of annual

earnings before interest and taxes in perpetuity regardless of its capital structure.

The firm immediately pays out all earnings as dividends at the end of each year.

OPC is subject to a corporate tax rate of 35 percent, and the required rate of return

on the firm’s unlevered equity is 20 percent. The personal tax rate on interest income

is 25 percent, and there are no taxes on equity distribution. Assume there are no

bankruptcy costs.

a.

What is the value of OPC if it chooses to retire all of its debt and become an

unlevered firm?

b.

What is the value of OPC if is decides to repurchase stock instead of retiring its

debt?

(

Hint:

Use the equation for the value of a levered firm with personal tax on inter-

est income from the previous problem.)

c.

Assume that expected bankruptcy costs have a present value of $400,000. How

does this influence OPC’s decision?

McKENZIE CORPORATION’S CAPITAL BUDGETING

Sam McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional com-

pany. Sam is considering opening several new restaurants. Sally Thornton, the company’s

CFO, has been put in charge of the capital budgeting analysis. She has examined the

potential for the company’s expansion and determined that the success of the new restau-

rants will depend critically on the state of the economy over the next few years.

McKenzie currently has a bond issue outstanding with a face value of $29 million that

is due in one year. Covenants associated with this bond issue prohibit the issuance of any

additional debt. This restriction means that the expansion will be entirely financed with

equity at a cost of $5.7 million. Sally has summarized her analysis in the following table,

which shows the value of the company in each state of the economy next year, both with

and without expansion:

Economic

Growth Probability

Without

Expansion With Expansion

Low .30 $25,000,000 $27,000,000

Normal .50 30,000,000 37,000,000

High .20 48,000,000 57,000,000

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?

2.

What is the expected value of the company’s debt in one year, with and without the

expansion?

3.

One year from now, how much value creation is expected from the expansion? How

much value is expected for stockholders? Bondholders?

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?

558

Part IV

Capital Structure and Dividend Policy

www.mhhe.com/rwj

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?

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?

Some Useful Formulas of Financial Structure

The Miller Model and the Graduated

Income Tax

To access the appendixes for this chapter, please visit www.mhhe.com/rwj.

 

 

 

 

Premium Custom Essays
Calculate your paper price
Pages (550 words)
Approximate price: -

Why Work with Us

Top Quality and Well-Researched Papers

We always make sure that writers follow all your instructions precisely. You can choose your academic level: high school, college/university or professional, and we will assign a writer who has a respective degree.

Professional and Experienced Academic Writers

We have a team of professional writers with experience in academic and business writing. Many are native speakers and able to perform any task for which you need help.

Free Unlimited Revisions

If you think we missed something, send your order for a free revision. You have 10 days to submit the order for review after you have received the final document. You can do this yourself after logging into your personal account or by contacting our support.

Prompt Delivery and 100% Money-Back-Guarantee

All papers are always delivered on time. In case we need more time to master your paper, we may contact you regarding the deadline extension. In case you cannot provide us with more time, a 100% refund is guaranteed.

Original & Confidential

We use several writing tools checks to ensure that all documents you receive are free from plagiarism. Our editors carefully review all quotations in the text. We also promise maximum confidentiality in all of our services.

24/7 Customer Support

Our support agents are available 24 hours a day 7 days a week and committed to providing you with the best customer experience. Get in touch whenever you need any assistance.

Try it now!

Calculate the price of your order

Total price:
$0.00

How it works?

Follow these simple steps to get your paper done

Place your order

Fill in the order form and provide all details of your assignment.

Proceed with the payment

Choose the payment system that suits you most.

Receive the final file

Once your paper is ready, we will email it to you.

Our Services

No need to work on your paper at night. Sleep tight, we will cover your back. We offer all kinds of writing services.

Essays

Essay Writing Service

No matter what kind of academic paper you need and how urgent you need it, you are welcome to choose your academic level and the type of your paper at an affordable price. We take care of all your paper needs and give a 24/7 customer care support system.

Admissions

Admission Essays & Business Writing Help

An admission essay is an essay or other written statement by a candidate, often a potential student enrolling in a college, university, or graduate school. You can be rest assurred that through our service we will write the best admission essay for you.

Reviews

Editing Support

Our academic writers and editors make the necessary changes to your paper so that it is polished. We also format your document by correctly quoting the sources and creating reference lists in the formats APA, Harvard, MLA, Chicago / Turabian.

Reviews

Revision Support

If you think your paper could be improved, you can request a review. In this case, your paper will be checked by the writer or assigned to an editor. You can use this option as many times as you see fit. This is free because we want you to be completely satisfied with the service offered.