McKenzie CORPORATION’S CAPITAL BUDGETING

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

CASE SUMMURYMcKenzie 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 to expand his business. 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. 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 $29millionCost of expansion $5.7millionValue of Company in a year With or Without???

Q1:Expected Value of the company with or without expansion

Without ExpansionE(V1) =PL*VL+PN*VN+PH*VH

= 0.30*25,000,000+0.50*30,000,000+0.20*48,000,000 =32,100,000($)

With ExpansionE(V2) =PL*VL+PN*VN+PH*VH

= 0.30*27,000,000+0.50*37,000,000+0.20*57,000,000 =38,000,000($)• 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 company’s 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.

Covenants are agreements that the stockholders always sign with the bondholder in hope of lower rate, because stockholders must pay

higher interest rates as insurance against their own selfish strategies.

• With or without expansion, the debt value will be equal to the company’s value under the low economic condition. This is because the company’s 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 company’s debt with or without expansionExpected Value for company with and without Expansion

Expected Value of Debt

Expected Value of Debt

Q2:Expected Value of the company’s debt and equity with or without expansion

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.

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.

- 0.4 million

0.6 million

0.2 million

Expected value for stockholder

Expected value for bondholders

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 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. 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 ExpansionIf 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 ExpansionIt 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.

cost

Free cash flow

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.

• 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.

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

Ways of expansion

Indirect cost

Protective covenants

MORE QUESTIONES

VT = S+B+G+L = VM+VN

Marketable nonmarketable claims claims

Think from the textbook-Capital Structure & value of firm

Value of firm

Bondholder claims

Shareholder claims

Tax claim (Government)

Bankruptcy claims(Lawyers and others)

As the company’s 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.

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.

Pecking-order Theory

Trade-off Theory

AGENCY COSTS

DISTRESS COSTS

TAX BENEFITS

TIMING

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 company’s 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...

Conclusion

• The nature of the present and future state of the economy are extremely pertinent to the company’s 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 company’s future borrowing needs and additional questions related to expansion versus not expanding is also needed before making decision.

NEWS

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.

US government hits debt limit againThe US government has once again hit its debt limit four months after Washington diffused last year's government shutdown.Under the budget deal passed by Congress in October, the debt limit was temporarily suspended to end the government shutdown.However, the federal government’s borrowing limit will reset on Saturday to the current level, which is about $17.2 trillion.The Treasury Department has resorted to “extraordinary measures” to stay under the debt limit and temporarily prevent a default.

Google to sell Motorola Mobility unit to LenovoAfter just a year and a half, Google is cutting the cord on Motorola Mobility.They sell its Motorola Mobility smartphone unit to Chinese PC maker Lenovo for $2.9 billion, giving up on a business it purchased for $12.5 billion in May 2012

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. Apples shares closed Friday up $7.17, or 1.4 percent, at $519.68