Question

Task #2: Tomewin Water Company

Role and Context

You are a newly-hired financial analyst with Tomewin Water Company (TWC), a company operating in most states of Australia, which specialises in bottling purified water sourced from Tweed Valley springs. TWC 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

TWC currently has 30,000,000 ordinary shares outstanding that trade at a price of $41 per share. TWC also has 500,000 bonds outstanding that currently trade at $923.38 each. The company’s bonds have 20 year to maturity, a $1,000 par value and a 8% coupon rate that pays interest semi-annually. TWC has no preferred equity outstanding and has an equity beta of 1.30. The risk free rate is 1.5% and the market is expected to return 11.5%. TWC has a tax rate of 30%.

The initial outlay for the new project is expected to be $3,000,000, 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 1,250,000 units per year at a price of $2.15 per unit. Variable costs are estimated to be $0.54 per unit and fixed costs are estimated at $50,000 per year. The above estimations are valid for 3 years of project life after which a terminal value of $500,000 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.

TWC’s CEO, Dr. Bob Green, has asked the finance department if they consider such project to be an acceptable investment. The CFO, Mrs. Sally Johnson, intends to evaluate the project based on the net present value approach. She agrees with Dr. Green on the major assumptions that will affect these cash flows, but they disagree on the appropriate discount rate. Dr. Green 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. To do this, Mrs. Johnson obtains some data for several comparable companies as follows:

Company	Cost of Equity	Cost of Debt	D/E	Tax Rate
Fruity Water	21.0%	8%	0.43	34%
Ladybug Drinks	19.70%	7.75%	0.35	36%

Task

1. The CEO and CFO have asked you to provide a recommendation on the appropriate discount rate to be used in the appraisal of the new project.

2. 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 1,000,000 units at a price of $1.85 and variable cost of $0.63 per unit;

b) Best Case: selling 1,550,000 units at a price of $2.25 and variable costs of $0.49 per unit.

3. Based on the above analysis, provide a recommendation on whether TWC should invest in this project.            

Answer 1

1.In the given case,company's weighted average cost of capital refers to minimum rate of return needed from an investment to make it worthwhile,whereas the discount rate is the rate used to discount the future cash flows from an investment to the present value to determine if an investment will be profitable.The discount rate takes into consideration the risk premium and thus usually higher than the weighted average cost of capital.

In the given case,company's WACC is as follows;

a)Cost of equity(Ke)=risk free rate+beta(Market return-risk free rate)

=1.5%+1.3(11.5%-1.5%)=14.5%

b)Weight of equity(We)=Value of equity/Value of equity+value of debt

=$41*30 million/$41*30 million+$923.38*0.5million

=$1230 million/$1691.69million

=0.73 or 73%

c)Cost of debt(Kd)=Coupon amount+(Face value-Purchase price)/Years to maturity/(Face value+Purchase price)/2

=($80)+($1000-923.38)/40/($1000+923.38)/2

=$81.9155/961.69

=0.08512 or 8.52% semi-annually

Thus cost of debt=8.52%*2=17.04%

Weight of debt(Wd)=1-weight of equity

=1-.73=0.27

d)WACC=Ke*We+Kd*(1-tax rate)*We

=14.5%*.73+7.04%(1-0.30)*0.27

=10.585%+1.33056%=11.92%

WACC of Fruity Water=21%*1/1.43+8%(1-0.34)*.43/1.43

=16.27%

WACC of Ladybug Drinks=19.70%*1/1.35+7.75%*(1-0.36)*.35/1.35

=15.88%

From the above,we can observe that company in the business of similar project has higher wacc,it means that the company need to add risk premium related to proposed project in its wacc to make it appropriate discount rate.