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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 rateis 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 initialoutlay 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 $0.24 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 from the company’s current products.

You have recently graduated with a degree in finance. Your employer, CWC wants you to work with the provided to data to address the given problems

a.Determine the weighted average cost of capital for CWC.

b.Should CWC go ahead with its proposed project of bottled water under the normal conditions as stated previously?

c.Should CWC go ahead with its proposed project of bottled water under the following best case and worst case scenarios?

Best –Case Scenario

Selling 2,500,000 units at a price of $1.24 per unit, with variable production costs of $0.22 per unit.

Worst –Case Scenario

Selling 950,000 units at a price of $1.32 per unit, with variable production costs of $0.27 per unit.

d.What would you do as the financial analyst? Which investment would you recommend, and why?

Weighted Average Cost of Capital Calculation

Value of shares = 30,000,000 * $ 42 = $

Determination of weighted average cost of capital for CWC

Cost of equity –

Ke = Rf  + β (Rm – Rf) (Magni 2015)

Where,

Ke = cost of equity

Rf  = Risk free rate = 3.5%

Β = Beta = 2.639

Rm = Market return = 12.52%

Therefore,

Ke = 3.5 + 2.639 * (12.52 – 3.5)

= 3.5 + 23.8038 = 27.3038%

Therefore, Ke or cost of equity = 27.3038%

Cost of bond –

Annual interest rate = 10% * 2 = 20%

Maturity = 20 years

Present value = 50,00,000 * $ 92.34 = $ 46,17,00,000

Face value = 50,00,000 * 100 = 50,00,00,000

Interest per year = 50,00,00,000 * 20% = $ 10,00,00,000

After tax interest = $ 10,00,00,000 * (1-0.34) = $ 660,00,000

Therefore, the effective rate = $ 660,00,000 / $ 50,00,00,000 = 0.132 or 13.20%

Cost of capital –

 

Amount

Weightage

Costs

Weightage * Costs

Ordinary shares

  1,260,000,000.00

0.7318

0.273

0.1998

Bonds

     461,700,000.00

0.2682

0.132

0.0354

Total

  1,721,700,000.00

1.0000

 

0.2352

 Therefore, the weighted average cost of capital = 23.52%

Calculation of depreciation –

Value of the project = $ 30,00,000

Salvage value = Nil

Useful life = 3 years

Depreciation method = Straight line

Therefore, depreciation = $ 30,00,000 / 3 = $ 10,00,000 per year

Calculation of cash flow

Particulars

Units

Amount

Sales (units)

1250000

Sales revenue (p.u)

 $                    1.25

Total sales revenue

 $ 1,562,500.00

Variable cost (p.u)

 $                    0.24

Total variable cost

 $    300,000.00

Contribution

 $ 1,262,500.00

Less: Fixed cost

 $    200,000.00

Net income before tax

 $ 1,062,500.00

Less tax @ 34%

 $    361,250.00

Net income after tax

 $    701,250.00

Add: Depreciation

 $ 1,000,000.00

Cash flow

 $ 1,701,250.00

Calculation of NPV

 

Year 1

Year 2

Year 3

Cash flows before tax

 $         1,062,500.00

 $   1,062,500.00

 $  1,062,500.00

Depreciation

 $         1,000,000.00

 $   1,000,000.00

 $  1,000,000.00

Income before taxes

 $              62,500.00

 $        62,500.00

 $       62,500.00

Taxes @ 34%

 $              21,250.00

 $        21,250.00

 $       21,250.00

Net income after tax

 $              41,250.00

 $        41,250.00

 $       41,250.00

Add: Depreciation

 $         1,000,000.00

 $   1,000,000.00

 $  1,000,000.00

Cash flow after tax

 $         1,041,250.00

 $   1,041,250.00

 $  1,041,250.00

After tax Terminal value

 $     330,000.00

Net cash flow after tax

 $         1,041,250.00

 $   1,041,250.00

 $  1,371,250.00

Discount rate @ 23.52%

0.810

0.656

0.531

Present value of cash flows

 $            843,117.41

 $      682,686.16

 $     727,973.83

Total

 $                                                                   2,253,777.40

Net present value –

= Present value of cash flows – Initial investment

= $ 22,53,770.40 – $ 30,00,000 = - $ 746,222.60

As the net present value of the project is negative, CWC shall not go ahead with the proposed project for bottled water under normal conditions as previously stated.

Best – case scenario

Calculation of cash flow

Particulars

Units

Amount

Sales (units)

         2,500,000.00

Sales revenue (p.u)

 $                    1.24

Total sales revenue

 $ 3,100,000.00

Variable cost (p.u)

 $                    0.22

Total variable cost

 $    550,000.00

Contribution

 $ 2,550,000.00

Less: Fixed cost

 $    200,000.00

Net income before tax

 $ 2,350,000.00

Calculation of NPV

 

Year 1

Year 2

Year 3

Cash flows before tax

 $         2,350,000.00

 $   2,350,000.00

 $  2,350,000.00

Depreciation

 $         1,000,000.00

 $   1,000,000.00

 $  1,000,000.00

Income before taxes

 $         1,350,000.00

 $   1,350,000.00

 $  1,350,000.00

Taxes @ 34%

 $            459,000.00

 $      459,000.00

 $     459,000.00

Net income after tax

 $            891,000.00

 $      891,000.00

 $     891,000.00

Add: Depreciation

 $         1,000,000.00

 $   1,000,000.00

 $  1,000,000.00

Cash flow after tax

 $         1,891,000.00

 $   1,891,000.00

 $  1,891,000.00

Terminal value

 $     330,000.00

Net cash flow after tax

 $         1,891,000.00

 $   1,891,000.00

 $  2,221,000.00

Discount rate @ 23.52%

0.810

0.656

0.531

Present value of cash flows

 $         1,531,174.09

 $   1,239,817.08

 $  1,179,091.98

Total

 $                                                                   3,950,083.15

 Net present value –

= Present value of cash flows – Initial investment

= $ 39,50,083.15 – $ 30,00,000 = $ 950,083.15

As the net present value of the project under best case scenario is positive, CWC shall go ahead with the proposed project for bottled water.

Worst – case scenario

Calculation of cash flow

Particulars

Units

Amount

Sales (units)

950,000.00

 

Sales revenue (p.u)

$                    1.32

 

Total sales revenue

 

$ 1,254,000.00

Variable cost (p.u)

$                    0.27

 

Total variable cost

 

$    256,500.00

Contribution

 

$    997,500.00

Less: Fixed cost

 

$    200,000.00

Net income before tax

 

$    797,500.00

Calculation of NPV

 

Year 1

Year 2

Year 3

Cash flows before tax

 $            797,500.00

 $      797,500.00

 $     797,500.00

Depreciation

 $         1,000,000.00

 $   1,000,000.00

 $  1,000,000.00

Income before taxes

 $          (202,500.00)

 $     (202,500.00)

 $    (202,500.00)

Taxes @ 34%

 $            (68,850.00)

 $       (68,850.00)

 $      (68,850.00)

Net income after tax

 $          (133,650.00)

 $     (133,650.00)

 $    (133,650.00)

Add: Depreciation

 $         1,000,000.00

 $   1,000,000.00

 $  1,000,000.00

Cash flow after tax

 $            866,350.00

 $      866,350.00

 $     866,350.00

Terminal value

 $     330,000.00

Net cash flow after tax

 $            866,350.00

 $      866,350.00

 $  1,196,350.00

Discount rate @ 23.52%

0.810

0.656

0.531

Present value of cash flows

 $            701,497.98

 $      568,014.56

 $     635,122.33

Total

 $                                                                   1,904,634.86

Net present value –

= Present value of cash flows – Initial investment

= $ 19,04,634.86 – $ 30,00,000 = - $ 10,95,365.15

As the net present value of the project under worst case scenario is negative, CWC shall not go ahead with the proposed project for bottled water.

As a financial analyst, a discussion shall be conducted with the company management to know their preference and clear them the factors associated with net present value. Further, the analyst shall go through the financial information for analysing the past period’s sales level and expected sales level of future (Gallo 2014).

The net present value is the technique used under capital budgeting for analysing the acceptability of the project. It includes funding of the future cash flows of the option and then discounting them for finding out the present value of the project and compares it with the initial investment (Lee and Lee 2015). Computation of net present value is incomplete if the income tax is not taken into consideration. Positive NPV represents that the estimated earnings from the project exceeds the initial investment and therefore, the project shall not be accepted or undertaken. On the contrary, the negative NPV represents that the estimated earnings from the project is lower than the initial investment and therefore, the project shall not be accepted or undertaken (Arrow et al. 2013).

Looking at the above scenarios and computation, it is found that only in case of best – case scenario the NPV of the project is positive that is $ 950,083.15. In other 2 cases that is under normal condition and under worst-case scenario the NPV of the project is negative. Therefore, CWC shall undertake the project only under best-case scenario.

Reference

Arrow, K., Cropper, M., Gollier, C., Groom, B., Heal, G., Newell, R., Nordhaus, W., Pindyck, R., Pizer, W., Portney, P. and Sterner, T., 2013. Determining benefits and costs for future generations. Science, 341(6144), pp.349-350.

Gallo, A., 2014. A refresher on net present value. Harvard Business Review, 19.

Lee, I. and Lee, K., 2015. The Internet of Things (IoT): Applications, investments, and challenges for enterprises. Business Horizons, 58(4), pp.431-440.

Magni, C.A., 2015. Investment, financing and the role of ROA and WACC in value creation. European Journal of Operational Research, 244(3), pp.855-866.

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