Capital Budgeting
Mini-Case Study: McKenzie Corporation’s Capital Budgeting
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
Growth
Probability Without
Expansion
Value Without
Expansion
Low 0.3 $
25,000,000.00
$
7,500,000.00
Normal 0.5 $
30,000,000.00
$
15,000,000.00
High 0.2 $
48,000,000.00
$
9,600,000.00
Expected value without expansion $
32,100,000.00
Economic
Growth
Probability Without
Expansion
Value With
Expansion
Low 0.3 $ $
Mini-Case Study: McKenzie Corporation’s Capital Budgeting 2
27,000,000.00 8,100,000.00
Normal 0.5 $
37,000,000.00
$
18,500,000.00
High 0.2 $
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.
Mini-Case Study: McKenzie Corporation’s Capital Budgeting 3
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)
Mini-Case Study: McKenzie Corporation’s Capital Budgeting 4
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.
Mini-Case Study: McKenzie Corporation’s Capital Budgeting 5
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
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 (10 th ed.). New York:
McGraw-Hill Irwin
