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BY-Group 3
Adnan Mohamed S Aleid, Rodolfo Marquez, Xi Zhang

McKenzie CORPORATIONS CAPITAL BUDGETING Sam McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional company. Sam is considering opening several new restaurants to expand his business. The companys CFO 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. The expansion will be entirely financed with equity due to the restriction of protective covenants at a cost that shown in the chart below. The capital structure of the company and value of the firm are also changed by expansion.
Debt Cost of expansion Value of Company in a year $29million $5.7million With or Without???

Q1:Expected Value of the company with or without expansion

Without Expansion E(V1) =PL*VL+PN*VN+PH*VH = 0.30*25,000,000+0.50*30,000,000+0.20*48,000,000

With Expansion E(V2) =PL*VL+PN*VN+PH*VH = 0.30*27,000,000+0.50*37,000,000+0.20*57,000,000


They would be better off with the expansion because they would making more value with it. Since the shareholders will be expected to eject an additional capital of 5.7 million, expansion increases the shareholders wealth by $200,000.

Q2:Expected Value of the companys debt with or without expansion

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.

The expected value of debt will be the same amount of $29 million because the expansion would be financed with equity.

Q2:Expected Value of the companys debt with or without expansion

Expected Value for company with and without Expansion

With or without expansion, the debt value will be equal to the companys value under the low economic condition. This is because the companys value is less than the face value of the debt. However, under both normal and high economic growth conditions for the two decisions, the value of the debt will be $29 million.

Q2:Expected Value of the companys debt and equity with or without expansion
Expected Value of Debt

Expected Value of Debt

Under the low economic growth condition, the value of equity will be zero for both with and without expansion decisions since the companys value will be less than the face value of the debt.

Q3:Expected Value creation from expansion

The gain for the bondholders is $600,000, the difference between the expected value of the bond with and without expansion. Similarly, the gain for the stockholders is $5,300,000.

The stockholders ejection into the company for the expansion is $5.7 million. This value is much higher than the increase in stockholder value of $5.3 million implying that the net present value of the stockholders investments is $400,000.

Expected value for stockholder

- 0.4 million

Expected value for bondholders

0.6 million

0.2 million

Expected value created

Q4:The Effect on Debt of the company, with or without expansion

Without Expansion Nothing changed in the value of bonds or the price of bonds as the status of bondholders remains unchanged as well This is because the bondholders expect that the management to act in the best interest of the shareholders. With Expansion The bondholders will realize that the management is not acting in the best interest of the shareholders and have prospects for future growth. There will be more equity making the debt-equity ratio decrease. The bonds return rate will also go down, which will result in an increase of the value of bonds and the price of bonds.

Q5:The implications for the companys future borrowing needs with or without expansion
A decision not to expand will not have an impact on the companys future borrowing needs since the contract for the bond has already been signed and is due in one year. On the other hand, a decision to expand sends a strong signal of the companys willingness to sacrifice for its bondholders. This decision may lead to lower interest rates in the future Without Expansion If the expansion does not happen then the equity will be the same next year as it is this year. When the debt covenants are over next year the company will not have greater equity so it may not be able to get the type of financing it is looking for to then do the expansion

With Expansion It the company does do the expansion then it will have to finance it thru equity. The expansion will create more equity for the company. The company will be able to get more financing after next year due to the debt covenants being done. This will help for borrowing needs for the future.

Q6:How would it affect if the expansion was financed with cash on hand instead of new equity? The expansion would be even better if it was financed with cash on hand, because then the company would not have to pay for the costs of changing equity into cash. Although the cost of financing would decrease if the expansion was financed with cash, the free cash flow of the company would decrease.


Free cash flow

Q6:How would it affect if the expansion was financed with cash on hand instead of new equity?
If the companys expansion is financed through issuance of new equity, the loss is shared between the existing and new shareholders.

If the company finances the expansion using cash in hand, the existing shareholders are responsible for the entire loss. This sends an even stronger willingness of the company to sacrifice for the bondholders, the implication being even lower interest rates for the loans in the future.

Protective covenants Indirect cost Ways of expansion

Covenants- cost of debt? Indirect cost? What if there is no covenant?

Think from the textbook-Capital Structure & value of firm

As the companys CFO, Sally may also try to choose a capital structure to maximize the value of the marketable claims, and equivalently to minimize the value of nonmarketable claims, which are taxes, bankruptcy costs, and all the other nonmarketable claims such as the LS claim.

Value of firm

Bondholder claims

Shareholder claims
Tax claim (Government) Bankruptcy claims(Lawyers and others)

VT = S+B+G+L = VM+VN
Marketable nonmarketable claims claims

Think from the textbook-Two Theories

Firms may always face the situation that they need new capital. Whether issuing debt or issuing equity is a direct decision to make. These two theories help managers to evaluate different choices. Under Trade-off theory, managers evaluate in terms of three issue, which are tax benefits, distress costs, and agency costs. While, manager only need to consider one item, timing. The two theory also have some implication which are at odds with each other.


Trade-off Theory

Practices are more complicated in real world than in the two theories

Think outside of the box

It is not just a simply answer to give. The decision made on capital structure has a long-term effect on the companys future success. Small company is so different from big guys when making decisions like this. When issuing Equity, top managers also need to consider agency costs like leisure time, work-related perquisites, and unprofitable investments, etc. More idea from you...

The nature of the present and future state of the economy are extremely pertinent to the companys financial success. Capital budgeting decisions are some of the most important decisions financial managers make because these decisions affect the success of firms. The amount of value creation from the expansion is needed for managers, along with how much value is expected for stockholders and bondholders. An evaluation of the companys future borrowing needs and additional questions related to expansion versus not expanding is also needed before making decision.

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