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McKenzie Restaurants - Capital budgeting analysis

Sam McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional company. Sam is considering opening several new restaurants. Sally Thorton, 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.
McKenzie currently has a bond issue outstanding with a face value of $25 million that is due in one year. Convenants associated with this bond issue prohibit the issuance of any additinal 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

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 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 financed with cash on hand instead of new equity?

Solution Preview

3. Expected value = summation of probability of a state*payoff under that state
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= 40.3 million
Change in expected Value due to expansion = 40.3-31.2=9.1 million
Net Value created by expansion = 9.1 million - 9 million = 0.1 million
Note: The investment required of 9.0 million is required for the expansion. Since no information is provided about how long ...

Solution Summary

This post answers a comprehensive problem on capital budgeting issues such as wealth created by expansion plans, pricing of bond and stocks, borrowing needs, bond covenant, growth from internal equity.