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 companys 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.

TWCs 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 companys weighted average cost of capital (WACC), however, the CFO disagrees, arguing that the bottled water targeted at children has different risk characteristics from the companys current products. She argues that the companys 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.