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    Analysing McKenzie expansion plans

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    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 of 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? Would the company's stockholders by better off with or without expansion? Why?

    2.What is the expected value of the company's debt in one year, with and without 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 if affect your answer if the expansion were fiananced with case on hand instead of new equity?

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    Solution Preview

    Please refer attached file for complete solution. Formulas written with the help of equation writer may not print here.

    Solution:

    1. What is the expected value of the company in one year, with and without expansion? Would the company's stockholders by better off with or without expansion? Why?

    Expected value =

    Expected value without expansion =0.3*20+0.5*34+0.2*41= 31.2 million

    Expected value with expansion =0.3*24+0.5*45+0.2*53-Cost of financing
    = 40.3-9 million
    =$31.3 million

    Since expected value of company is higher in case of expansion is more, shareholders will be better off with expansion.

    2. What is the expected value of the company's debt in one year, with and without expansion?

    Expected value of debt in one year will remain $25 million with or without expansion as entire financing will be ...

    Solution Summary

    Solution explains the steps for determining expected profit with or without expansion plans. It also discusses the effect of its expansion plans on its bondholders and shareholders.

    $2.19

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