Mini Case - Mckenzie Corporation's Capital Budgeting

Issuing additional debt to finance the company expansion would worsen the company’s debt ratio as it is already more than average. The company envisions to be profitable by raising capital from existing stockholders by issuing common stock through rights offering.

As for the combination of cash and new shares, shareholders can take part of their money

In general, using external funds, i.e. debt or equity, to finance increasing growth is riskier to the corporation. When issuing debt the company needs to be certain to cover both the repayment of the principal and the interest payments on time (because if they do not this could cause them to have problems securing financing in the future). When issuing additional shares of stock (equity) the value of existing traded stock is diluted (in proportion) and as such the current ownership might lose control (and may even be voted out by shareholders if dilution is substantial enough). Furthermore, with both debt and equity financing, a fast growing company needs to be aware that payments to either may hamper future expansion because payments that need to be send out in the forms of dividends or interest cannot be retained and invested in future projects.

The company position is strong enough so its better that company should use debt financing instead of equity financing.

AS MR. WILSON 'S FINANCIAL ADVISER, WOULD YOU URGE HIM TO GO AHEAD WITH, OR TO RECONSIDER, HIS ANTICIPATED EXPANSION AND HIS PLANS FOR ADDITIONAL DEBT FINANCING ?

a) How many shares will the firm have to issue, assuming they issue the new shares at the current price per share?

Shareholder’s equity would be lower than that shown in 1982 ($318,000) because the company has to pay off interest and principal for many loans. There will be little money left for shareholder’s equity.

5. If Marriott used a signle corporate hurdle rate for evaluating investment opportunities in each of its lines of business, what would happen to the company over time?

The number of shares outstanding will remain the same and thus, the only change in the equity side of the balance sheets for the next three years will be the change in the amount of retained earnings. This change will be equal to the net income of the company for last year because the company will not pay a dividend.

How much value do you expect to be created by operating improvements and capital structure changes envisioned by CD&R?

* A broader capital base gives the company more access to credit which gives the company an option to venture into new business opportunities

There are two ways of increasing capital, (1) using debt and (2) issuing new shares. For profitable companies sometimes it is cheaper to use debt instead of issuing new shares since cost of debt is tax shielded. In this case company didn’t have any debt in past which means less default risk, it will affect total value in a positive way. It will decrease the taxes paid and increase net income, accordingly share values.

If the company benefits from the provision of the bond, then the coupon rate will be higher. If the bondholder’s benefit, then the bond will have lower coupon rate.

One of the assumptions of the management is that they assume no acquisitions will be made in 2007. If the management decides to acquire other companies in 2007 and if they decided not to repurchase stocks, they will be able to use the 230M cash or borrow debt to finance the acquisition. And this would have little impact on financial stability. If they decided to repurchase stocks, they won’t be able to finance the acquisition with cash account, and the only way left is by borrowing more debt. And this probably have minor to major impact on financial stability depending how much the company decide to borrow.

Q3. Does the company have any other sources that it could use to raise the funds it requires? Explain. (In your answer consider the amount required and the purpose of the funds). In which market can these funds be sourced from?