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Mckenzie Corporation's 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 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 over the next few years.
McKenzie currently has a bond issue outstanding with a face value of $26 million that is due in
one year. Covenants associated with this bond issue prohibit the issuance of any additional
[Link] restriction means that the expansion will be entirely financed with equity at a cost of
$5.4 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 With
Expansion Expansion
Low 0.30 $22,000,000 $29,000,000
Normal 0.50 $31,000,000 $37,000,000
High 0.20 $48,000,000 $54,000,000
1. What is the expected value of the company in one year, with and without expansion? Would
the company's stockholders be better off with or without expansion? Why?
The expected value of the company in one year without expansion is:
V = 0.30($22,000,000) + 0.50($31,000,000) + 0.20($48,000,000)
V = $31,700,000
The expected value of the company in one year with expansion is:
V = 0.30($29,000,000) + 0.50($37,000,000) + 0.20($54,000,000)
V = $38,000,000
The company shareholder should be better off with the expansion because the value of the
company would increase by $6,300,000 ($38,300,000 - $31,700,000 ).
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2. What is the expected value of the company's debt in one year, with and without the
expansion?
The expected value of debt in one year without expansion is:
VD = 0.30($22,000,000) + 0.50($26,000,000) + 0.20($26,000,000)
VD = $24,800,000
The value of the company’s debt in one year with expansion is:
VD = 0.30($26,000,000) + 0.50($26,000,000) + 0.20($26,000,000)
VD = $26,000,000
3. One year from now, how much value creation is expected from the expansion? How much
value is expected for stockholders? Bondholders?
The expected value of the equity without expansion is:
VE = 0.30($0) + 0.50($5,000,000) + 0.20($22,000,000)
VE = $6,900,000
And the expected value of equity with expansion is:
VE = 0.30($3,000,000) + 0.50($11,000,000) + 0.20($28,000,000)
VE = $12,000,000
With expansion, the expected value for company’s bondholders is:
Bondholder gain = $26,000,000 – $24,800,000
Bondholder gain = $1,200,000
And the expected value for stockholders is:
Stockholder gain = $12,000,000 – $6,900,000
Stockholder gain = $5,100,000
The expected NPV of expansion for stockholders is:
Stockholder NPV = –$5,400,000 + 5,100,000
Stockholder NPV = –$300,000
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At face value, stockholders lose $0.3M, but since they expect future benefits, we need to
discount future gains using Net Present Value
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?
If the company does not expand, the bondholders’ status remains unchanged because there is
no change in the value of bonds. If the company expands, more equity will be created, and the
debt-to-equity ratio will decrease. This can lower the rate of return on company bonds.
Additionally, the value and price of the bonds will increase.
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?
If the company does not expand, equity remains unchanged in the next year since expansion
does not take place. If the company expands, it will finance the expansion through equity,
increasing the company’s total equity. This growth in equity will also support future borrowing
needs.