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Role and Context You are a newly hired financial analyst with Gold...

Role and Context

You are a newly hired financial analyst with Gold Coast Water Company (GCWC), a company operating in Queensland, which specialists 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 50,000,000 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 1,550,000 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. Cost of Equity Cost of Debt  D/E  Beta Tax Rate

 Sunny Water 15.73% 7% 0.35 1.65 32%

Labrador Drinks 17.34% 7.55% 0.4. 1.85 34%


Task

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 & Explanation
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