Question

The following question is a two-part homework question from Corporate Finance 11th Edition. The mini-case study on McKenzie Corporation Capital Budgeting. PLEASE SHOW ALL CALCULATIONS. Thank you.

McKENZIE CORPORATION’S CAPITAL BUDGETING (Case Study):

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 $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 $5.7 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 $22,000,000

Normal .50 $25,000,000 $32,000,000

High .20 $43,000,000 $52,000,000

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?

Answer 1

Expected Total Value of company

Without expansion:

(0.30*20)+(0.50*25)+(0.20*43)=

27.1

Millions

So, value of Equity= 27.1-25(debt)= 2.1 mlns.

With expansion:

(0.30*22)+(0.50*32)+(0.20*52)=

33

Millions

So, value of Equity= 33-25(debt)= 8 mlns.

If expansion were financed with cash on hand instead of new equity

Value of Equity will remain the same 8 millions,

as cash decreased will increase the permanent or working capital assets , needed for expansion.

Also assets-Debt= equity

New equity flotation costs are saved &

the company can use its excess funds ,instead of declaring any dividends.