McKenzie CORPORATION’S CAPITAL BUDGETINGBY-Group 3 Adnan Mohamed S Aleid, Rodolfo Marquez, Xi Zhang .7million With or Without??? . Inc. The expansion will be entirely financed with equity due to the restriction of protective covenants at a cost that shown in the chart below.CASE SUMMURY McKenzie CORPORATION’S CAPITAL BUDGETING Sam McKenzie is the founder and CEO of McKenzie Restaurants. Debt Cost of expansion Value of Company in a year $29million $5. Sam is considering opening several new restaurants to expand his business. a regional company. The capital structure of the company and value of the firm are also changed by expansion. The company’s CFO has examined the potential for the company’s expansion and determined that the success of the new restaurants will depend critically on the state of the economy over the next few years. 000.000+0.20*48.30*25.000.000($) • • They would be better off with the expansion because they would making more value with it.000 =32.000($) With Expansion E(V2) =PL*VL+PN*VN+PH*VH = 0.000.50*30.000+0.000+0.Q1:Expected Value of the company with or without expansion Without Expansion E(V1) =PL*VL+PN*VN+PH*VH = 0.50*37.30*27.000.000.7 million.000.100. .000+0. expansion increases the shareholders wealth by $200.000.20*57. Since the shareholders will be expected to eject an additional capital of 5.000.000 =38. Q2:Expected Value of the company’s debt with or without expansion Covenants associated with this bond issue prohibit the issuance of any additional debt. . The expected value of debt will be the same amount of $29 million because the expansion would be financed with equity. This restriction means that the expansion will be entirely financed with equity at a cost of $5.7 million. .Q2:Expected Value of the company’s debt with or without expansion Expected Value for company with and without Expansion • With or without expansion. • However. the value of the debt will be $29 million. This is because the company’s value is less than the face value of the debt. under both normal and high economic growth conditions for the two decisions. the debt value will be equal to the company’s value under the low economic condition. .Q2:Expected Value of the company’s 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 company’s value will be less than the face value of the debt. 300.2 million Expected value created .4 million Expected value for bondholders 0.6 million 0.7 million.Q3:Expected Value creation from expansion • The gain for the bondholders is $600. This value is much higher than the increase in stockholder value of $5.000.000. • The stockholders’ ejection into the company for the expansion is $5.000. Expected value for stockholder . the gain for the stockholders is $5.3 million implying that the net present value of the stockholders’ investments is –$400. Similarly.0. the difference between the expected value of the bond with and without expansion. The bonds’ return rate will also go down. which will result in an increase of the value of bonds and the price of bonds. . • 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.Q4:The Effect on Debt of the company. There will be more equity making the debt-equity ratio decrease. 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. . The company will be able to get more financing after next year due to the debt covenants being done. On the other hand. a decision to expand sends a strong signal of the company’s 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. The expansion will create more equity for the company. This will help for borrowing needs for the future.Q5:The implications for the company’s future borrowing needs with or without expansion A decision not to expand will not have an impact on the company’s future borrowing needs since the contract for the bond has already been signed and is due in one 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. Although the cost of financing would decrease if the expansion was financed with cash. cost Free cash flow . because then the company would not have to pay for the costs of changing equity into cash. the free cash flow of the company would decrease.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. the implication being even lower interest rates for the loans in the future. This sends an even stronger willingness of the company to sacrifice for the bondholders. • If the company finances the expansion using cash in hand.Q6:How would it affect if the expansion was financed with cash on hand instead of new equity? • If the company’s expansion is financed through issuance of new equity. . the loss is shared between the existing and new shareholders. the existing shareholders are responsible for the entire loss. cost of debt? • Indirect cost? • What if there is no covenant? .MORE QUESTIONES Protective covenants Indirect cost Ways of expansion • Covenants. and all the other nonmarketable claims such as the LS claim. bankruptcy costs. which are taxes. Sally may also try to choose a capital structure to maximize the value of the marketable claims. 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-Capital Structure & value of firm As the company’s CFO. and equivalently to minimize the value of nonmarketable claims. distress costs. manager only need to consider one item. Pecking-order Theory Trade-off Theory • • • Practices are more complicated in real world than in the two theories . Under Trade-off theory. While. managers evaluate in terms of three issue. Whether issuing debt or issuing equity is a direct decision to make. which are tax benefits. The two theory also have some implication which are at odds with each other. timing. and agency costs. These two theories help managers to evaluate different choices.Think from the textbook-Two Theories • Firms may always face the situation that they need new capital. • • • . When issuing Equity.. and unprofitable investments.Think outside of the box • It is not just a simply answer to give. etc. The decision made on capital structure has a long-term effect on the company’s future success. More idea from you. top managers also need to consider agency costs like leisure time. work-related perquisites. Small company is so different from big guys when making decisions like this.. along with how much value is expected for stockholders and bondholders. • The amount of value creation from the expansion is needed for managers.Conclusion • The nature of the present and future state of the economy are extremely pertinent to the company’s financial success. • An evaluation of the company’s future borrowing needs and additional questions related to expansion versus not expanding is also needed before making decision. . • Capital budgeting decisions are some of the most important decisions financial managers make because these decisions affect the success of firms. 5 billion in May 2012 . NE WS Google to sell Motorola Mobility unit to Lenovo After just a year and a half.4 percent. Apple takes $14B bite of its stock via buyback Apple has repurchased $14 billion of its stock in the two weeks after its first-quarter financial results and second-quarter revenue outlook disappointed investors.2 trillion. They sell its Motorola Mobility smartphone unit to Chinese PC maker Lenovo for $2. the debt limit was temporarily suspended to end the government shutdown.Billions missing from Sochi 2014 Winter Olympics fund The Russian government and its allied tycoons have been accused by a renowned Kremlin critic of stealing billions of dollars assigned for construction of the 2014 Winter Olympics in Sochi. Google is cutting the cord on Motorola Mobility. Apples shares closed Friday up $7.9 billion.68 US government hits debt limit again The US government has once again hit its debt limit four months after Washington diffused last year's government shutdown. which is about $17.17. or 1. However. Under the budget deal passed by Congress in October. The Treasury Department has resorted to “extraordinary measures” to stay under the debt limit and temporarily prevent a default. giving up on a business it purchased for $12. at $519. the federal government’s borrowing limit will reset on Saturday to the current level.
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