Calculation Of Weighted Average Cost Of Capital And Project Analysis For Cascade Water Company
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.