Question

You are a newly hired financial analyst with Gold Coast Water Company (GCWC), a company operating in Queensland, which specialises in bottling purified water sourced from Tambourine Mountains springs. GCWC is considering adding to its product mix a 'healthy' bottled water geared towards children, aimed at improving both its business focus and the return to shareholders. Scenario GCWC currently has 30,000,000 ordinary shares outstanding that trade at a price of $35 per share. GCWC also has 400,000 bonds outstanding that currently trade at $983.38 each. The company's bonds have 20 year to maturity, a $1,000 par value and a 10% coupon rate that pays interest semi-annually.

GCWC has no preferred equity outstanding and has an equity beta of 2.21. The risk-free rate is 2.5% and the market is expected to return 10.52%. GCWC has a tax rate of 34%. The initial outlay for the new project is expected to be $5,000,000, which will be depreciated over the next 3 years using the straight line method to a zero salvage value, and sales are expected to be 1,650,000 units per year at a price of $2.05 per unit. Variable costs are estimated to be $0.62 per unit and fixed costs are estimated at $75,000 per year. The above estimations are valid for 3 years of project life after which a terminal value of $580,000 in year 3 is expected to cover all cash flows to be earned in the future. For the purpose of this project, working capital effects are ignored. GCWC's CEO, Ben Waters, has asked the finance department if they consider such project to be an acceptable investment.

The CFO, Mrs. Alexandra Robinson, intends to evaluate the project based on the net present value approach. She agrees with Mr. Waters on the major assumptions that will affect these cash flows, but they disagree on the appropriate discount rate. Mr. Waters believes that they should use the company's weighted average cost of capital (WACC), however, the CFO disagrees, arguing that the bottled water targeted at children has different risk characteristics from the company's current products. She argues that the company's WACC is inappropriate as a discount rate and they should instead use the 'pure play' approach and estimate a cost of capital based on companies that sell similar type of products. Mrs. Robinson obtains some data for several comparable companies as follows:

Company: Sunny Water

Cost of Equity 12.12%

Cost of Debt 7%

D/E 0.35

Beta 1.2

Tax Rate 32%

Company: Labrador Drinks

Cost of Equity 12.93%

Cost of Debt 7.55%

D/E 0.40

Beta 1.3

Tax Rate 34%

The CEO and CFO have decided to rely on your newfound expertise as to provide a recommendation on why the company's WACC should not be used, and if not, what is the appropriate discount rate to be used in the appraisal of the new project.

Concerned about the forecasting risk of this project, they also ask that you perform a risk evaluation in the form of: - Sensitivity analysis for sales price, variable costs, fixed costs and unit sales at ±10%, ±20%, and ±30% from the base case, showing on a graph which variables are most sensitive; - Scenario analysis on the following two scenarios:

a) Worst Case: selling 1,250,000 units at a price of $1.75 and variable cost of $0.68 per unit;

b) Best Case: selling 1,750,000 units at a price of $2.25 and variable costs of $0.49 per unit. Based on the above analysis provide a recommendation whether GCWC should invest in this project.

Answer 1

First of all, lets get all the financial extracted from the case of simplifies calculations:-

Bond Data	Bonds	400,000
	Current Price of Bond	$983.38
	Duration	20	years
	Face Value	$1,000
	Coupon Rate	10%	semi annually
	Current Yield	10.45%

current yield is being calculated by the YTM formula, so we can get the present cost of capital of the GCWC.

	Ordinary Shares	30,000,000
	Trading Price	$35

Equity Shares	Equity Beta	2.21
	Risk free rate	2.50%
	Market Return	10.52%
	Cost equity	20.22%	By CAPM method

CAPM (Capital Asset pricing model) is being used here for calculating the cost of equity for GCWC.

Formula for CAPM model for your reference is given below:-

Expected Return = Risk Free Rate + Beta*( Market Return - Risk Free rate)

Lets Get the WACC ( Weighted Average Cost of Capital) of GCWC. Following the data required for WACC calculation:-

Total Value of Equity (E)	$1,050,000,000
Total Value of Debt (D)	$393,352,000.00
Re	20.22%
Rd	10.45%
Tax Rate	34%

• Total Value of equity share is being calculated by multiplying the no. of shares with the current price of the shares.
• Total value of debt is being calculated by multiplying the total no bonds to the current price of the bond.
• Re is the cast of equity we get from CAPM.
• Rd is the cost of debt we get from YTM.
• Tax rate is given in the case.

Formula for calculating WACC is as below

E= market value of Firm's equity

D=market value of firm's debt

V=D+E

by using above formula we get WACC as 16.59%

Now lets use NPV formula to know if the investment will be a good idea or not.

Initial Investment	$5,000,000
Depreciation	3	years (Straight Line)
Salvage Value	0
Expected sales/ year	1,650,000
Per unit cost	$2.05	per unit
Variable Cost	$0.62	per unit
Fixed cost	$75,000
Terminal value of sales	$580,000

Year	Cash Flow	Present Value	Description
1	$3,382,500.00	$2,901,137.92	Cash flow is calculated by multiplying the expected sales with per unit cost
2	$3,382,500.00	$2,488,278.27	The Cash is being discounted by the GCWC WACC.
3	$580,000	$365,948
	Total Present Value	$5,755,364.47	as the PV is more that $5,000,000, this investment is a good idea.

Lets Use Pure Play method to get the Present Value of our investment by taking the reference of Sunny Water.

Sunny Water	Cost of Equity	12.12%
	Cost of Debt	7%	WACC of Sunny Waters	9.54%	Kindly Refer the above formula	Year	Cash Flow	Present Value
	D/E	0.35				1	$3,382,500.00	$3,087,800.34
	Beta	1.2				2	$3,382,500.00	$2,818,776.32
	Tax Rate	32%				3	$580,000	$441,227
							Total Present Value	$6,347,803.79	Present Value is Greater the the investment hence its a good idea to get in this proposal.

Lets Use Pure Play method to get the Present Value of our investment by taking the reference of Labrador Water.

Labrador Waters	Cost of Equity	12.93%
	Cost of Debt	7.55%	WACC of Labrador Waters	10.40%	Kindly Refer the above formula	Year	Cash Flow	PV
	D/E	0.4				1	$3,382,500.00	$3,063,922.53
	Beta	1.3				2	$3,382,500.00	$2,775,349.96
	Tax Rate	34%				3	$580,000	$431,070
							Total Present Value	$6,270,342.61

Present Value is Greater the the investment hence its a good idea to get in this proposal.

We must accept the WACC of our company itself as per my view it is much more realistic than the other two companies data given.

Worst Case Scenario:-

Expected sales/ year	1,250,000				Year	Cash Flow	PV
Per unit cost	$1.75	per unit			1	$2,187,500.00	$1,876,197.84
Variable Cost	$0.68	per unit			2	$2,187,500.00	$1,609,196.96
Fixed cost	$75,000				3	$580,000	$365,948
Terminal value of sales	$580,000					Total Present Value	$3,851,343.08	Bad Idea

Best Case Scenario:-

Expected sales/ year	1,750,000				Year	Cash Flow	PV
Per unit cost	$2.25	per unit			1	$3,937,500.00	$3,377,156.12
Variable Cost	$0.49	per unit			2	$3,937,500.00	$2,896,554.53
Fixed cost	$75,000				3	$580,000	$365,948
Terminal value of sales	$580,000					Total Present Value	$6,639,658.92	Very Good Idea

By Doing Sensitivity analysis, I will suggest the management team to analyse the Macro factors of the economy before investing into this project.

W ACC = (E/V) * Re+ (D/V) * Rd*(1 - Tc)