Weighted Average Cost Of Capital, NPV And Decision Making For Cascade Water Company

Determining the weighted average cost of capital for CWC

a.Value of shares = 30,000,000 * $ 42 = $

Computation of weighted average cost of capital of CWC (Magni 2015)

Cost of equity –

K_e = R_f  + β (R_m – R_f)

Where,

K_e = cost of equity

R_f  = Risk free rate = 3.5%

Β = Beta = 2.639

R_m = Market return = 12.52%

Therefore,

K_e = 3.5 + 2.639 * (12.52 – 3.5)

      = 3.5 + 23.8038 = 27.3038%

Therefore, K_e 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

Hence, weighted average cost of capital = 23.52%

b.Computation of depreciation –

Value of 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

Computation 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

It can be seen from the above calculation that the resultant NPV of project is in negative that is – $ 746,222.60 (Žižlavský 2014). Therefore, CWC shall not accept the proposed project of bottled water as per previously stated normal condition.  

c.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

It can be seen from the above calculation that the resultant NPV of project is positive  that is $ 950,083.15. Therefore, CWC shall accept the proposed project of bottled water as per best case scenario.  

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

It can be seen from the above calculation that the resultant NPV of project is in negative that is – $ 10,95,365.15. Therefore, CWC shall not accept the proposed project of bottled water as per worst case scenario.   

d.As the financial analyst, before providing any suggestions the analyst shall gain complete knowledge of the client’s business, their preference and requirements. Further, he shall arrange a meeting with the concerned person to explain the brief idea regarding net present value and associated factors. Moreover, he shall go through the last year’s financial records and the projected budget to analyse the sales level and cash flow (Lee and Lee 2015). 

The NPV is the difference among the present value of the cash inflows and outflows over the specific period of the time. It is used under capital budgeting for analyzing the profitability of project or investment in a project. If the NPV of the project is positive it indicates that the earnings created from the investment exceeds the projected costs. Generally a project with positive NPV is regarded as profitable and with negative NPV is regarded as the project that will generate loss. This is the basic rule for NPV that states that the investment shall be made with the project only that has positive NPV (Pasqual, Padilla and Jadotte 2013). It takes into consideration the below mentioned 2 inputs –

• Target rate of return that is hurdle rate
• Projected cash inflows from the project in successive periods

Further, it takes into account the time value of money that makes it better approach for the technique of investment appraisal as compared to other methods like IRR.  

Taking into consideration the above presented computations, it is observed that the resultant NPV of project is positive that is $ 950,083.15 only under best case scenario. The NPV under current scenario as well under worst case scenario is negative. Therefore, CWC shall accept the proposed project of bottled water under best case scenario only.    

References

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.

Pasqual, J., Padilla, E. and Jadotte, E., 2013. Equivalence of different profitability criteria with the net present value. International Journal of Production Economics, 142(1), pp.205-210.

Žižlavský, O., 2014. Net present value approach: method for economic assessment of innovation projects. Procedia-Social and Behavioral Sciences, 156, pp.506-512.