MCKENZIE CORPORATION’S CAPITAL BUDGET

MCKENZIE CORPORATION’S CAPITAL BUDGET

Akshay Monde

Ottawa University

BUS-7600

Prof. Keith Wade

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McKenzie Corporation’s Capital Budget

Sam McKenzie is the founder and CEO of McKenzie Restaurants and Sally Thornton is

its CFO. Sally manages capital budgeting analysis and looks for the company’s potential

expansion. McKenzie has an outstanding bond with a face value of $26 million due in one year

and equity of $5.4 million. The following table shows the company’s value with and without

expansion.

Question 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?

Answer:

Value without expansion = 0.30 * 22 + 0.5 * 31 + 0.2 * 48

= 31.7 million

Value with expansion = 0.3 * 29 + 0.5 * 37 + 0.2 * 54

= 43.7

Share holder’s additional capital = 43.7 – 31.7 – cost of financiang = 6.6 million

Since they will be making 6.6 million more with the expansion, they should expand.

Question 2: What is the expected value of the company’s debt in one year, with and without the

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expansion?

Answer: Expected value of firm’s debt without expansion = $24.8 million.

The expected value of firm’s debt with expansion = $26.9 million.

Question 3: One year from now, how much value creation is expected from the expansion? How

much value is expected for stockholders? Bondholders?

Answer:

The gain of the bond for bondholders is 2.1 million (26.9-24.8).

Value of the equity without expansion = 0.5(31-26) + 0.2(48-26) = 6.9 million

Value of the equity with expansion = 0.5(37-26) + 0.2(54-26) = 11.1 million

Stockholder’s expected value = 5.4 – (11.1-6.9) = 0.2 million

Bond holder’s expected value =$5,600,000

Question 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?

Answer: If the company announces to expand there will be more equity and thus equity debt

ratio will decrease. This will result in increased value and prices of the bonds. If the company

decides not to expand then there will be no change in bond price and remains unchanged.

Question 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?

Answer: If the company decides to expand, it will have more equity and will get more financing

next year by attracting shareholders. If the company decides not to expand then it will have the

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 MCKENZIE CORPORATION’S CAPITAL BUDGET
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same equity and thus will not be able to collect the financing required for expansion.

Question 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: It will be better if the financing of the expansion is done by cash in hand. If expansion

is done by cash then only existing shareholders are responsible for losses. If expansion is

financed by new equity then losses are shared by new as well as old shareholders.

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References

Ross, P., Westerfield, R., & Jaffe, J. (2019). Corporate finance (12th ed.). McGraw-Hill.

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