# McKenzie Corporation’s Capital Budgeting

McKenzie Corporation’s Capital Budgeting

Button Inc. purchased a factory on July 1, 2006 for \$1,320,000. At that time, the municipal tax notice indicated an assessed value of \$275,000 for the land and \$825,000 for the building. The building’s useful life was estimated at 45 years with a residual value of \$55,000.

On July 1, 2010, modifications were made to the building’s structure to address safety deficiencies. These modifications cost \$165,000 and were expected to extend the useful life of the building by 6 years while maintaining the building’s residual value of \$55,000.

On June 30, 2014, the building was burned to the ground as a result of an electrical fire. An insurance settlement of \$945,000 was received immediately and will be used to rebuild the factory on the existing site.

Required: Assume the company uses the straight -line method for depreciation and the fiscal year end is June 30

a) Calculate the amount of depreciation taken on the building between July 1, 2006 and June 30, 2014.

b) Calculate the amount of gain or loss to be reported as a result of the insurance settlement

1./

EXPECTED VALUE WITHOUT EXPANSION = 0.3 * 25 + 0.5 * 30 + 0.2 * 48= \$32.1 MILLION

EXPECTED VALUE WITH EXPANSION = 0.3 * 27 + 0.5 * 37 + 0.2 * 57 – COST OF FINANCING

= 38 – 5.7 MILLION

=\$32.3 MILLION

THEY WOULD BE BETTER OFF WITH THE EXPANSION BECAUSE THEY WOULD BE MAKING 0.2 MILLION MORE WITH IT.

=32.3 – 32.1 = 0.2 MILLION

2./

THE EXPECTED VALUE OF DEBT WILL BE THE SAME AMOUNT OF \$29 MILLION BECAUSE THE EXPANSION WOULD BE FINANCED WITH EQUITY.

3./

EXPECTED VALUE WITHOUT EXPANSION = 0.3 * 25 + 0.5 * 30 + 0.2 * 48= \$32.1 MILLION

EXPECTED VALUE WITH EXPANSION = 0.3 * 27 + 0.5 * 37 + 0.2 * 57 – COST OF FINANCING

= 38 – 5.7 MILLION

=\$32.3 MILLION

NET VALUE CREATED BY EXPANSION = 32.3 – 32.1 = 0.2 MILLION
SINCE THE DEBT VALUE WOULD REMAIN THE SAME THEN THE ADDITION WOULD BE FOR THE STOCKHOLDERS
EXPECTED VALUE FOR STOCKHOLDER = 0.2 MILLION AND FOR BONDHOLDERS = 0.

4./

IF THE COMPANY DOES NOT EXPAND, THERE WILL BE NO CHANGE IN THE VALUE OF BONDS AS THE STATUS OF BONDHOLDERS REMAINS UNCHANGED AS WELL

IF THE EXPANSIONS HAPPENS THEN THERE WILL BE MORE EQUITY MAKING THE DEBT TO EQUITY RATION DECREASE.

THIS WILL MAKE THE RATE OF RETURN ALSO GO DOWN ON THE COMPANY BONDS.

THIS WILL ALSO MAKE THE VALUE OF BONDS AND THE PRICE OF BONDS INCREASE IN VALUE.

5./

IF THE EXPANSION DOES NOT HAPPEN THEN THE EQUITY WILL BE THE SAME NEXT YEAR AS IT IS THIS YEAR. WHEN THE DEBT CONVENANTS ARE OVER NEXT YEAR THE COMPANY WILL NOT HAVE GREATER EQUITY SO IT MAY NOT BE ABLE TO GET THE TYPE OF FINANCING IT IS LOOKING FOR TO THEN DO THE EXPANSION

IT THE COMPANY DOES DO THE EXPANSION THEN IT WILL HAVE TO FINANCE IT THRU EQUITY. THE EXPANSION WILL CREATE MORE EQUITY FOR THE COMPANY. THE COMPANY WILL BE ABLE TO GET MORE FINANCING AFTER NEXT YEAR DUE TO THE DEBT CONVENANTS BEING DONE. THIS WILL HELP FOR BORROWING NEEDS FOR THE FUTURE.

6./

THE EXPANSION WOULD LOOK EVEN BETTER IF IT WERE FINANCED WITH CASH ON HAND BECAUSE THEN THE COMPANY WOULD NOT HAVE TO PAY FOR THE COSTS OF CHANGING EQUITY INTO CASH

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