Expansion: Finance and Debt Equity Ratio
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
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
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.