Problem:
Sam Huang is the owner of a business. Meanwhile he is examining the potential for the company's expansion. Currently, his company has a bond issue outstanding with a face value of $25 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 $9 million. He has summarized his analysis in the following table, which shows that 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 0.30 $20,000,000 $24,000,000
Normal 0.50 $34,000,000 $45,000,000
High 0.20 $41,000,000 $53,000,000
(a). 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?
(b) What is the expected value of the company's debt in one year, with and without the expansion?
(c). One year from now, how much value creation is expected from the expansion? How much value is expected for stockholders? Bondholders?
(d) 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 expansion?
(e). If the company opts not to expand, what are the implications for the company's future borrowing needs? What are implications if the company does expand?
(f). 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?