Sam McKenzie is the founder and CEO of McKenzie Restaurants, Inc. a regional com

Question

Sam McKenzie is the founder and CEO of McKenzie Restaurants, Inc. a regional company. Sam is considering opening several new restaurants. Sam Thornton, the company's CEO, has been put in charge of the capital budgeting analysis. She has examined the potential for the company's expansion and determined that the success of the new restaurants will depend critically on the state of the economy next year and over the next few years.
McKenzie currently has a bind issue outstanding with a face value of $14 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 $4.5 million. Sally has summarized her analysis in the following table, which shows the value of the company in each state of the economy next year with both expansion and without.
Economic Growth Probability W/O Expansion W/ Expansion
Low .30 $11,000,000 $13,000,000
Normal .50 $17,500,000 $24,000,000
High .20 $22,500,000 $28,500,000

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?

Explanation / Answer

Economic Growth Probability Without Expansion With Expansion Low .30 $22,000,000 $26,000,000 Normal .50 $35,000,000 $48,000,000 High .20 $45,000,000 $57,000,000 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? ? Expected value without expansion =0.3*22+0.5*35+0.2*45= 33.1 million ? Expected value with expansion =0.3*26+0.5*48+0.2*57-Cost of financing = 43.2-9 million =$34.2 million ? They would be better off with the expansion because they would be making 1.1 million more with it. =34.2 -33.1=1.1 million 2. What is the expected value of the company’s debt in one year, with and without the expansion? ? The expected value of debt will be the same amount of $28 million because the expansion would be financed with equity. 3. One year from now, how much value creation is expected from the expansion? How much value is expected for stockholders? Bondholders? ? Expected value without expansion =0.3*22+0.5*35+0.2*45= 33.1 million ? Expected value with expansion =0.3*26+0.5*48+0.2*57-Cost of financing = 43.2-9 million =$34.2 million ? Net Value created by expansion =34.2 -33.1=1.1 million ? Since the debt value would remain the same then the addition would be for the stockholders ? Expected value for stockholder = 1.1 million and for bondholders = 0. 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? ? 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 company opts not to expand, what are the implications for the company’s future borrowing needs? What are the implications if the company does expand? ? 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. 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? ? 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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