McKenzie Restaurants Capital Budgeting

Sally McKenzie is the founder and CEO of McKenzie Restaurants Inc., a regional company. Sally isconsidering opening several new restaurants. Sam Thornton, the company$$s CFO, has been put incharge of the capital budgeting analysis. He has examined the potential for the company$$s expansionand determined that the success of the new restaurants will depend critically on the state of theeconomy over the next few years.

McKenzie currently has a bond issue outstanding with a face value of $$29$ million that is due in oneyear. Covenants associated with this bond issue prohibit the issuance of any additional debt. Thisrestriction means that the expansion will be entirely financed with equity at a cost of $$5\mathrm{.}7$ million.Sam has summarized his analysis in the following table, which shows the value of the company ineach state of the economy next year, both with and without expansion:

Economic growth Probability Without Expansion With Expansion

Low $0\mathrm{.}30$ $$25,000,000$ $$27,000,000$

Normal $0\mathrm{.}50$ $$30,000,000$ $$37,000,000$

High $0\mathrm{.}20$ $$48,000,000$ $$57,000,000$

$1.$ What is the expected value of the company in one year, with and without expansion?

$2.$ What is the expected value of the 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 valueis expected for shareholders? Bondholders?

$4.$ If the company announces that it is not expanding, what do you think will happen to the price ofits 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 borrowingneeds? 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?