McKenzie Corporations 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 companys CFO, has been put in charge of the capital budgeting analysis. She has examined the potential for the companys 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?

2.What is the expected value of the companys 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 companys future borrowing needs? What are the implications if the company does expand?