Cascade Water Company (CWC) currently has 30,000,000 shares of common stock outs

Question

Cascade Water Company (CWC) currently has 30,000,000 shares of common stock outstanding that trade at a price of $42 per share. CWC also has 500,000 bonds outstanding that currently trade at $923.38 each. CWC has no preferred stock outstanding and the beta of its common stock is 2.639. The risk-free rate is 3% and the required return on the market is 12.5%. The firms bonds have 20 years to maturity, a $1,000 par value, a 10% annual coupon rate with semiannual coupons. 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, and 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 $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 operating cash flows for year 3) of $500,000. CWC has a 34% tax rate. For purposes of this project, working capital effects will be ignored. Bottled water targeted at children is expected to have different risk characteristics from the firms current products. Therefore, CWC has decided to look for other firms with products similar to the proposed project. They have identified the following two firms and their common stock betas. Firm Beta Fruity Water 1.72 Ladybug Drinks 1.84 Assignment 1. Determine the current weighted average cost of capital for CWC. Remember to show you calculations in finding the different components of WACC: financing proportions, component costs of capital. 2. Determine the appropriate cost of capital for the healthy bottled water project using the average of the betas for the two companies above as the beta for calculating the cost of common stock. Leave your other cost of capital components from #1 the same. 3. What are the expected cash flows for the healthy water project? 4. Should CWC under take the healthy water project? Support your conclusion.

Explanation / Answer

Ans;

A company has different sources of finance, namely common stock, retained earnings, preferred stock and debt. Weighted average cost of capital (WACC) is the average after tax cost of all the sources. It is calculated by multiplying the cost of each source of finance by the relevant weight and summing the products up. Formula For a company which has two sources of finance, namely equity and debt, WACC is calculated using the following formula: Cost of equity is calculated using different models for example dividend growth model and capital asset pricing model. Cost of debt is based on the yield to maturity of the relevant instruments. If no yield to maturity can be calculated we can base the estimate on the instrument's current yield, etc. The weights are based on the target market values of the relevant components. But if no market values are available we base the weights on book values. Example Company ? has a 1 million shares of common stock currently trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta of 1.2. It also has 10,000 bonds with of $1,000 pare paying 10% coupon annually maturing in 20 years currently trading at $900. The company's tax rate is 35%. Calculate the weighted average cost of capital. Solution: First we need to calculate the weights of debt and equity. Market Value of Equity = 1,000,000 $30 = $30,000,000 Market Value of Debt = 50,000 $950 = $47,500,000 Total Market Value of Debt and Equity = $77,500,000 Weight of Equity = $30,000,000 / $77,500,000 = 38.71% Weight of Debt = $47,500,000 / $77,500,000 = 61.29% Weight of Debt can be calculated as 100% minus cost of equity = 100% ? 38.71% = 61.29% Second step in our solution is to calculate the cost of equity. With the given data we can use capital asset pricing model (CAPM) to calculate cost of equity as follows: Cost of Equity = Risk Free Eate + Beta Mrket Risk Premium = 4% + 1.2 8% = 13.6% We also, need to find the cost of debt. Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find that yield to maturity is 10.61%. After tax cost of debt is hence 10.61% ( 1 ? 30% ) = 7.427% And finally, WACC = 38.71% 13.6% + 61.29% 7.427% = 9.8166%

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