Sam Wilson Case

Debt increases the cost of equity and debt reduces taxes in capital structure. Therefore, debt does impact the value of the firm. (IFT, 2012) In the case analysis, Sam McKenzie is considering opening new restaurants and has consulted the CFO, Sally Thornton with assistance with capital budgeting. The prosperity for the new restaurants relies heavily on the state of the economy over the next few years. The company has an outstanding bond in the amount of $25 million that is due at the end of the year. This means that the expansion will be entirely financed with equity at a cost of $5. 7million.The following chart is provided for reference:
Economic Growth Probability Without Expansion With Expansion
Low .30 $20,000,000 $22,000,000
Normal .50 25,000,000 32,000,000
Would the company’s stockholder be better off with or without the expansion? Why?
Expected value in one year with the expansion=(P times WE) Low =$6.6 Normal = $16 and High = $10.4 which equals $33 Million. Subtract the cost of financing and the expected value in one year = $27.3 Million
Expected Value in one year without the expansion = (P times W/Out E ) Low =$6 Normal = $12.5 High = $8.6 which equals $27.1 Million
The expected value of with and without the expansion differs by $200,000. Because the NPV is positive the stockholders should accept the project.
2. What is the expected value of the company’s debt in one year, with or without the expansion? Considering the expansion is financed using equity, and the outstanding debt is $25 million, the debt would remain the same without the
Notably, Ross, Westerfield, Jaffe, and Jordan (2016) state, “The firm should select the capital structure that gets the most cash into the hands of its investors.” (p.542)
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?
Considering the debt to equity ratio, if the company decided to decline the expansion there would be no change to the value of the bonds. Although, if the company accepted the expansion then the debt to equity ratio will decline which will decrease the rate of return for the company. “Firms with uncertain operating income have a high profitability of experiencing financial distress, even without debt. Thus, these firms must finance mostly with equity.” (Ross, Westerfield, Jaffe, & Jordan, 2016, p.547)
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