The CFO has been charged of capital budgeting analysis for McKenzie Restaurant. She has examined 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 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. The CFO has summarized her analysis, showing 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
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?
2) What is the expected value of the company's debt in one year, with and without the 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?