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Expected value

One year with expansion

Expected value of the company in one year with expansion

(0.3 * 11 = 3.3) + (0.5 * 17.5 = 8.75) + (0.2 * 22.5 = 4.5) = $ 16.55 Million

One year without expansion

Expected value of the company in one year without expansion

(0.3*13) + (0.5 * 24) + (0.2 * 28.5) = $ 21.6 Million

The company’s stockholders will be better off without expansion. This is because the company’s value is more without expansion. Company’s value symbolizes shareholder value. A company is made up of debt and equity.

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The amount of finance that does not form part of equity is therefore the debt of the company as follows:

Debt in one year with the expansion

Expected value of the company's debt in one year with the expansion

16.55 - 4.5 – $ 12.05Million

Debt in one year without the expansion

Expected value of the company's debt in one year without the expansion:

This will be $14 Million since the company has a no-additional-debt rule.

Value creation

One year from now the value creation expected from the expansion will be:

Value of company with expansion less value of company without expansion= 16.55 -21.6 = $-5.05Million

  • for stockholders

Company value expected for stockholders

With expansion: 16.55-14 =$ 2.55 Million

  • for bondholders

Company value expected for bondholders

With expansion: $ 14 Million, without expansion: $ 14 Million

This is the same since the company’s debt remains constant, as there is a rule that no additional debt should be added.

Company value expected for bondholders

With expansion: 16.55 – 12.05 = $ 4.5 Million, without expansion: 21.6 – 17.1 = $ 4.5 Million

If the company announces that it is not expanding, the price of its bonds will increase. Stockholders will anticipate a reduction in the value of the company and will therefore withdraw. This means the company will have to restructure and think of how to finance using bonds. However due to the company’s debt policy it will have to issue more shares for subscription or issuing bonus shares.

If the company does expand, stockholders will be more interested in buying its shares. The company will also have to issue an initial public offer to finance its new investments. Both of these will result in increase in proportion of company consisting of equity. More bondholders will also shift to buy shares, a situation, which will be quick if the company has convertible bonds.

If the company opts not to expand, it will have to borrow more funds in future. Stockholders are already anticipating that the company will expand. If they receive different news, they will begin withdrawing their shares. This will leave the company with lesser funds, forcing it to undertake a debt financing. However due to the company’s debt policy it will refinance by issuing more shares for subscription or issuing bonus shares

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If the expansion were financed with cash on hand instead of new equity, the shareholders’ value will increase significantly. However the liquidity of the company will be low and it may lack operating cash for day to day activities. The business will have less cash balance. Only firms with a suitable balance of cash in hand can reinvest this cash into the firm to drive the establishment to gaining more and more cash hence more profit.

Enough cash balance also enables the company to be able to remunerate the staff in time as well as clear debts accruing to creditors. If the expansion continues to be done through cash in hand, this may result into the firm becoming insolvent. Should this occur continuously, the firm might become bankrupt.

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