Case Cascade Water Company (CWC) currently has 30,000,000 shares of ordinary sha

Question

Case Cascade Water Company (CWC) currently has 30,000,000 shares of ordinary shares outstanding that trade at a price of $42 per share. CWC also has 5,000,000 bonds outstanding that currently trade at $92.34 each CWC has no preferred shares 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 company's bonds have a 20- year life, a $100 face 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 for the project is expected to be $3,000,000, which will be depreciated using the straight-line method to a zero salvage value sales are expected to be 1,250,000 units per year at a price of $1.25 per unit. Variable costs are estimated to be S0.24 per unit, and fixed costs of the project are estimated at $200,000 per year. The project is expected to have a three-year life and a terminal value (excluding the operating cash flows in year 3) of $500,000 CWC has a 34% tax rate. (For the purposes of this project, working capital effects will be ignored) Bottled water targeted at children is expected to have different risk characteristics fronm the company's current products

Explanation / Answer

(a):

Weighted average cost of capital:

Cost of equity as per capital asset pricing model is

Rf + beta X (Rm - Rf)

Rf=3.5%

Rm=12.52%

Beta = 2.639

Cost of equity (3.5% + (12.52 - 3.5) x 2.639

9.02

23.80378

27.30378

27.30%

Cost of bond

Interest

10

Market value

92.34

Cost of bond (10 x 100/92.34)

10.82954

Cost of bond

10.83%

Sources

(A): Numbers

(B): Market value

©: Total market value (AXB)

(D): Proportion of sources

(E) Cost (As calculated)

(F): Weighted average cost (DxE)

Equity share capital

30000000

42 per share

1260000000

0.731835

27.30%

0.199791

Bond

5000000

92.34 per bond

461700000

0.268165

10.83%

0.029042

Total capital

1721700000

0.228833

Thus, weighted average cost of capital

22.88%

                 

(b):

Sales

1250000

1.25

1562500

Less: Variable costs

1250000

0.24

300000

Contributions

1262500

Less: Fixed costs

200000

1062500

Less: depreciation

500000

Profit before tax

562500

Less: Tax @34%

191250

Profit after tax

371250

Add: Depreciation

500000

Cash flow each year

871250

Year

Cash inflow

Present value factor @22.88%

Present value of cash inflow

1

871250

0.813802

       709,025.07

2

871250

0.662274

       577,006.08

3

871250

0.53896

       469,568.75

4

871250

0.438607

       382,136.02

5

871250

0.356939

       310,983.09

Terminal value

500000

0.356939

       178,469.49

Present value of total cash inflow

   2,627,188.50

Less: Initial investment in the project

   3,000,000.00

Net present value

    (372,811.50)

Depreciation per year

Initial investment

3000000

Less: Terminal value

500000

Depreciable amount

2500000

Year

5

Depreciation each year (2500000 / 5)

500000

No, the project should not be accepted as the net present value of the project is negative.

(c):

Best case scenario

Sales

2500000

1.24

3100000

Less: Variable costs

2500000

0.22

550000

Contributions

2550000

Less: Fixed costs

200000

2350000

Less: depreciation

500000

Profit before tax

1850000

Less: Tax @34%

629000

Profit after tax

1221000

Add: Depreciation

500000

Cash flow each year

1721000

Year

Cash inflow

Present value factor @22.88%

Present value of cash inflow

1

1721000

0.813802

   1,400,553.39

2

1721000

0.662274

   1,139,773.26

3

1721000

0.53896

       927,549.86

4

1721000

0.438607

       754,842.01

5

1721000

0.356939

       614,292.00

Terminal value

500000

0.356939

       178,469.49

Present value of total cash inflow

   5,015,480.00

Less: Initial investment in the project

   3,000,000.00

Net present value

   2,015,480.00

Project should be accepted under best case scenario as the net present value of the project is positive under the base case scenario

Worst case scenario

Sales

950000

1.32

1254000

Less: Variable costs

950000

0.27

256500

Contributions

997500

Less: Fixed costs

200000

797500

Less: depreciation

500000

Profit before tax

297500

Less: Tax @34%

101150

Profit after tax

196350

Add: Depreciation

500000

Cash flow each year

696350

Year

Cash inflow

Present value factor @22.88%

Present value of cash inflow

1

696350

0.813802

       566,691.08

2

696350

0.662274

       461,174.38

3

696350

0.53896

       375,304.67

4

696350

0.438607

       305,423.72

5

696350

0.356939

       248,554.46

Terminal value

500000

0.356939

       178,469.49

Present value of total cash inflow

   2,135,617.82

Less: Initial investment in the project

   3,000,000.00

Net present value

    (864,382.18)

The project should not be accepted under worst case scenario as the net present value of the project is negative under worst case scenario.

(d):

Since the net present value of the project in base case scenario is negative, i.e. the expected sales is 1250000 units with a price of $1.25 each the net present value of the project is -$372811.50. Thus, the Company should not invest in the project. However, if the possibility of selling 2500000 units at a price of $1.24 per unit is relatively high then the company should consider investing the project s in that scenario the expected net present value of the project

Weighted average cost of capital:

Cost of equity as per capital asset pricing model is

Rf + beta X (Rm - Rf)

Rf=3.5%

Rm=12.52%

Beta = 2.639

Cost of equity (3.5% + (12.52 - 3.5) x 2.639

9.02

23.80378

27.30378

27.30%

Cost of bond

Interest

10

Market value

92.34

Cost of bond (10 x 100/92.34)

10.82954

Cost of bond

10.83%

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