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

Question

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 $11.2 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 $3.6 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. 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? What is the expected value of the company's debt in one year, with and without the expansion? One year from now, how much value creation is expected from the expansion? How much value is expected for stockholders? Bondholders? 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 opts not to expand, what are the implications for the company's future borrowing needs? What are the implications if the company does expand? 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

1) Expected value of the company within one year, with and without expansion, is $13,240,000 & $17,280,000 respectively. Value without Value with Expected value Economic growth Probability expansion expansion without expn with expn Low 0.3 8800000 10400000 2640000 3120000 Normal 0.5 14000000 19200000 7000000 9600000 High 0.2 18000000 22800000 3600000 4560000 Expected value of the company 13240000 17280000 Value of debt 11200000 11200000 Value of equity 2040000 6080000 Less: increase in equity (raised for the expansion project) 3600000 Increase in value of equity 2480000 The company's stock holders would be better off, as the equity value goes up with expansion by $2.48 millions, after deducting the equity raised for the expansion. 2) It is the same at $11.2 million. 3) Value creation is $2480000. The entire value creation goes to the stockholders; the bond holders get nothing. 4) If the company announces that it is expanding, the price of the bonds will remain the same. But, if it announces the expansion, the equity goes up with decrease in the debt/equity ratio. This will reduce the risk for the bond holders. As a result the required rate on the bond goes down and the value of the bond would go up. 5) With or without expansion the company cannot borrow for one year. Once the existing bonds are retired the company, the company can decide its capital structure and can borrow accordingly. With expansion the equity will be more and the company can have more borrowing capacity as the debt outstanding will be zero. Without expansio debt capacity will be lower. 6) It would be financing through retained earnings, which will help avoid the issue costs associated with raising new equity. Cost of equity and WACC will be lower. It will create more value.

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