QUESTION:
Cascade Water Company (CWC) currently has 30 000 shares of common stock outstanding, trading at a price of R42 per share. CWC also has 500 000 bonds outstanding that are currently trading at R923.38 per bond. 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%.
CWC is considering adding 'healthy' bottled water geared toward children to its product mix. The initial outlay for the project is expected to be R3 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 R1.25 per unit. Variable costs are estimated to be R0.24 per unit, and fixed costs of the project are estimated at R200 000 per year. The project is expected to have a three year life and a terminal value (excluding the operating cash flows in year three) of R500 000. CWC operates in a 34% marginal tax rate. For the purposes of this project, working capital effects will be ignored. Bottled water with a focus toward children is expected to have different risk characteristics from the firm's current products. As such, 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
|
|
Equity Water
|
1.75
|
0.43
|
34%
|
|
Ladybug Drinks
|
1.84
|
0.35
|
36%
|
a. Determine the current weighted average cost of capital for CWC.
b. Determine the appropriate discount rate for the healthy bottled water project.
c. Should the firm undertake the healthy bottled water project? As part of your analysis, include a sensitivity analysis for sales price, variable costs, fixed costs, and unit sales +-10%, 20%, and 30% from base case. Also perform a scenario analysis assuming: the best case is to sell 2 500 000 units at a price of R1.24 each, with variable costs of production of R0.22 per unit; and the worst case scenario of selling only 950 000 units at a price of R1.32 per unit, with variable costs of production of R0.27 per unit.