You are a newly hired financial analyst with Gold Coast WaterCompany (GCWC), a company operating in Queensland, whichspecialises in bottling purified water sourced from TambourineMountains springs. GCWC is considering adding to its product mix a'healthy' bottled water geared towards children, aimed at improvingboth its business focus and the return to shareholders. ScenarioGCWC currently has 30,000,000 ordinary shares outstanding thattrade at a price of $35 per share. GCWC also has 400,000 bondsoutstanding that currently trade at $983.38 each. The company'sbonds have 20 year to maturity, a $1,000 par value and a 10% couponrate that pays interest semi-annually.
GCWC has no preferred equity outstanding and has an equity betaof 2.21. The risk-free rate is 2.5% and the market is expected toreturn 10.52%. GCWC has a tax rate of 34%. The initial outlay forthe new project is expected to be $5,000,000, which will bedepreciated over the next 3 years using the straight line method toa zero salvage value, and sales are expected to be 1,650,000 unitsper year at a price of $2.05 per unit. Variable costs are estimatedto be $0.62 per unit and fixed costs are estimated at $75,000 peryear. The above estimations are valid for 3 years of project lifeafter which a terminal value of $580,000 in year 3 is expected tocover all cash flows to be earned in the future. For the purpose ofthis project, working capital effects are ignored. GCWC's CEO, BenWaters, has asked the finance department if they consider suchproject to be an acceptable investment.
The CFO, Mrs. Alexandra Robinson, intends to evaluate theproject based on the net present value approach. She agrees withMr. Waters on the major assumptions that will affect these cashflows, but they disagree on the appropriate discount rate. Mr.Waters believes that they should use the company's weighted averagecost of capital (WACC), however, the CFO disagrees, arguing thatthe bottled water targeted at children has different riskcharacteristics from the company's current products. She arguesthat the company's WACC is inappropriate as a discount rate andthey should instead use the 'pure play' approach and estimate acost of capital based on companies that sell similar type ofproducts. Mrs. Robinson obtains some data for several comparablecompanies 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 expertiseas to provide a recommendation on why the company's WACC should notbe used, and if not, what is the appropriate discount rate to beused in the appraisal of the new project.
Concerned about the forecasting risk of this project, they alsoask that you perform a risk evaluation in the form of: -Sensitivity analysis for sales price, variable costs, fixed costsand unit sales at ±10%, ±20%, and ±30% from the base case, showingon a graph which variables are most sensitive; - Scenario analysison the following two scenarios:
a) Worst Case: selling 1,250,000 units at a price of $1.75 andvariable cost of $0.68 per unit;
b) Best Case: selling 1,750,000 units at a price of $2.25 andvariable costs of $0.49 per unit. Based on the above analysisprovide a recommendation whether GCWC should invest in thisproject.
