Sam Dugan is the founder and CEO of Dugan 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.

Dugan currently has a bond issue outstanding with a face value of $9.3 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 $3.7 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.

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 stockholders? Bondholders?

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?

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?

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Economic Growth Probability Without Expansion With Expansion Low .30 $ 6,900,000 $ 8,400,000 Normal .50 12,000,000 17,200,000 High .20 16,000,000 20,700,000