Capital Structure

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 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, both with and without expansion. Economic Growth Low Normal High Probability .30 .50 .20 Without Expansion $20,000,000 $34,000,000 $41,000,000 With Expansion $24,000,000 $45,000,000 $53,000,000 1. What is the expected value of the company in one year, with and without expansion? Would the company’s stockholders be 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 it affect your answer if the expansion were financed with cash on hand instead of new equity?

anyone help with this Q? thanks.

The questions are a little vague without knowing some other information. Does the firm want to keep the same capital structure in the future? I invite someone to correct my answers, because frankly…they are guesses. 1) Without expansion is .3*20,000,000 + .5*34,000,000 + .2*41,000,000 = 31,200,000. Similarly, with expansion = 40,300,000. The cost of expansion is 9,000,000. Therefore, the stockholders should expect 100,000 more value with the expansion. 2) I assume this means that they will not issue new debt if the value of the firm has increased above the 25 million that will be owed, so I am not sure I understand the question. The value of the debt will be the 25 million face value stated above. I could be missing something here though…look at answer to 5. 3) Stockholders should expect 100,000 in value creation. Bond holders will not participate in any company valuation gain, so they should not expect anything other than the face value and original YTM. 4) I assume that the price would decline if they announce that they will not expand. By expanding, they are adding more equity to the capital structure, thereby reducing debt equity ratios. 5) If they do expand, they should expect to have to refinance the debt for 25,000,000 -(40,300,000 - 25,000,000) = 9,700,000. If they do not expand, it will cost 18,800,000 to refinance. This is simply assuming that the firm is averse to debt, will pay as much of it off as possible with the economic growth, and only refinance what is necessary going forward. 6) I don’t have an answer here. Cash would be preferable than new equity assuming they had the cash position to do so, but as I stated at the beginning, the questions are lacking much needed given information.