MINI CASE 1

McKenzie Restaurants Capital Budgeting

Sally McKenzie is the founder and CEO of McKenzie Restaurants Inc., a regional company. Sally is considering opening several new restaurants. Sam Thornton, the companys CFO, has been put in charge of the capital budgeting analysis. He 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 over the next few years.

McKenzie currently has a bond issue outstanding with a face value of $29 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 $5.7 million. Sam has summarized his 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 growthProbability

Without

Expansion

With

Expansion

Low0.30$25,000,000$27,000,000Normal0.50$30,000,000$37,000,000High0.20$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 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 shareholders? 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 companys 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?

MINI CASE 2

Electronic Timing Ltd.

Electronic Timing Ltd. (ETL) is a small company founded 15 years ago by electronics engineers Jessica Kerr and Tom Miller. ETL manufactures integrated circuits to capitalize on the complex mixed-signal design technology and has recently entered the market for frequency timing generators, or silicon timing devices, which provide the timing signals or clocks necessary to synchronize electronic systems. Its clock products were originally used in PC video graphics applications, but the market subsequently expanded to include motherboards, PC peripheral devices, and other digital consumer electronics, such as digital television boxes and game consoles. ETL also designs and markets custom application-specific integrated circuits (ASICs) for industrial customers. The ASICs design combines analog and digital, or mixed-signal, technology. In addition to Jessica and Tom, Norma Pittman, who provided capital for the company, is the third primary owner. Each owns 25 percent of the 1 million shares outstanding. Several other individuals, including current employees, own the remaining company shares.

Recently, the company designed a new computer motherboard. The companys design is both more efficient and less expensive to manufacture, and the ETL design is expected to become standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, ETL determined that the costs involved in building a new plant would be prohibitive. The owners also decided that they were unwilling to bring in another large outside owner. Instead, ETL sold the design to an outside firm. The sale of the motherboard design was completed for an after-tax payment of $30 million.

1. Jessica believes the company should use the extra cash to pay a special one-time dividend. How will this proposal affect the stock price? How will it affect the value of the company?
2. Tom believes the company should use the extra cash to pay off debt and upgrade and expand its existing manufacturing capability. How would Toms proposals affect the company?
3. Norma is in favor of a share repurchase. She argues that a repurchase will increase the companys P/E ratio, return on assets (ROA), and return on equity (ROE). Are her arguments correct? How will a share repurchase affect the value of the company?
4. Another option discussed by Jessica, Tom, and Norma is to begin a regular dividend payment to shareholders. How would you evaluate this proposal?
5. One way to value a share of stock is the dividend growth, or growing perpetuity, model. Consider the following. The dividend payout ratio is 1 minus b, where b is the retention or plowback ratio. So, the dividend next year will be the earnings next year, E1, times 1 minus the retention ratio. The most commonly used equation to calculate the sustainable growth rate is the ROE times the retention ratio. Substituting these relationships into the dividend growth model, we get the following equation to calculate the price of a share of stock today:

What are the implications of this result in terms of whether the company should pay a dividend or upgrade and expand its manufacturing capability? Explain.