McKenzie Corporation’s Capital Budgeting
Sam McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional company. Sam is considering opening several new restaurants. Sally Thornton, the company’s CFO, 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 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. Sally has summarized her analysis in the following table, which shows the 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 .30 $20,000,000 $24,000,000
Normal .50 $34,000,000 $45,000,000
High .20 $41,000,000 $53,000,000
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?
2.What is the expected value of the company’s debt in one year, with and without the expansion?
3.One year from now, how much value creation is expected from the expansion? How much value is expected for stockholder? Bondholders?
4.If the company announces that it is not expanding, what do you think will happen to the price of the bonds? What will happen to the price of the bonds if the company does expand?
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?
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?
Submitted: 1137 days and 3 hours ago.
Economic Growth Probability Without Expansion Value of Debt(a) Value to all Shareholders
Low 0.3 $20,000,000 20,000,000 $0
Normal 0.5 $34,000,000 25,000,000 $9,000,000
High 0.2 $41,000,000 25,000,000 $16,000,000
Expected Value $31,200,000 $23,500,000 $7,700,000
a) The value of debt is the value of the firm up to $25M. I.e. if the value of the firm is less than $25M then the debt holders have a claim to remaining value of the firm
Economic Growth Probability With Expansion Value of Debt(a) Value to all Shareholders Change in shareholder value
Low 0.3 $24,000,000 24,000,000 $0
Normal 0.5 $45,000,000 25,000,000 $20,000,000 $11,000,000
High 0.2 $53,000,000 25,000,000 $28,000,000 $12,000,000
Expected Value $40,300,000 $24,700,000 $15,600,000
Expected Values Without Expansion With Expansion Change
1. Company Value $31,200,000 $40,300,000 $9,100,000
Stakeholders would be better off, the return to stockholders requires further steps
2. Debt $23,500,000 $24,700,000 $1,200,000
1.2M of the 9.1M gain in company value is captured by the bond holders
3. By expanding, $9.1M of value is created for both bond and equity holders, $.1M net of new equity.
$1.2M is created for bond holders and $7.9M for equity holders. Net of equity, $1.2M is created for bond holders and -$1.1M for equity holders.
4. Price of Bonds $0.94 $0.99
With expansion the price of bonds will be $.99, if it doesn't expand the price will fall back to $.94
1b. Shareholders $7,700,000 $15,600,000 $7,900,000
1b. Shareholders after funding $7,700,000 $6,600,000 $(1,100,000)
Stockholders would be worse off since their expected value grew by less than the amount of new funds they put into the company.
5. With or without expansion, there is a 30% chance the company will require additional funding to remain operating (Low economic growth rate)