Cascade water company (CWC) currently has 30,000,000 shares of common stock out-

Question

Cascade water company (CWC) currently has 30,000,000 shares of common stock out-standing that trade at a price of $42 per share. CWC also has 500,000 bonds outstanding that currently trade at $923.38 per share. CWC has no preferred stock outstanding and has an equity beta of 2.639. The risk-free rate is 3.5% and the market is expected to return 12.52%. The firms bonds have a 20-year life, a $1,000 par value, a 10% coupon rate and pay interest semi-annually.

CWC is considering adding to its product mix a “healthy” bottled water geared toward children. The initial outlay of the product is expected to be $3,000,000, which will be depreciated using the straight-line method to a zero salvage value and sales are expected to be 1,250,000 per year at a price of $1.25 per unit. Variable costs are expected to be $0.24 per unit, and fixed costs of the project are estimated at $200,000 per year. The project is expected to have a 3-year life and a terminal value (excluding the operational cash flows in year 3) of $500,000. CWC has a 34% marginal tax rate. For the purpose of this project, working capital effects will be ignored. Bottled water targeted at children is expected to have different risk characteristics form the firm’s current projects. Therefore, CWC has decided to use the “pure play” approach to evaluate this project. After researching the market, CWC managed to find two “pure-play” firms. The specifics for those two firms are:

Firm

Equity Beta

D/E

Tax Rate

Fruity Water

1.72

0.43

34%

Ladybug Drinks

1.84

0.35

36%

Determine the current weighted average cost of capital for CWC

Firm

Equity Beta

D/E

Tax Rate

Fruity Water

1.72

0.43

34%

Ladybug Drinks

1.84

0.35

36%

Explanation / Answer

Step 1:

1) Cost of Common Stock = Rf + (Rm-Rf)*Beta

Cost of Common Stock = 3.5 + (12.52-3.5)*2.639

Cost of Common Stock = 27.30%

2) Before Tax Cost of Debt = rate(nper,pmt,pv,fv) *2

Before Tax Cost of Debt = rate(40,50,-923.38,1000) * 2

Before Tax Cost of Debt = 10.95 %

After Tax Cost of Debt = Before Tax Cost of Debt *(1-tax rate)

After Tax Cost of Debt = 10.95*(1-34%)

After Tax Cost of Debt = 7.23%

Step 2:

Market Value of Common Stock = 30Milion * 42 = $ 1260 Million

Market Value of Bond = 0.5 Million * 923.38 = $ 461.69 Million

Total Market Value = $ 1721.69Million

Weight of Common Stock = 1260/1721.69

Weight of Debt = 461.69/1721.69

Step3:

WACC = Weight of Common Stock* Cost of Common Stock + Weight of Debt* After Tax cost of Debt

WACC = 1260/1721.69*27.30 +  461.69/1721.69*7.23

WACC = 21.92%

Answer

current weighted average cost of capital for CWC = 21.92%

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