Question

Suppose a beverage company is considering adding a new product line.
Currently the company sells apple juice and they are considering selling a fruit drink.
The fruit drink will have a selling price of $1.00 per jar. The plant has excess capacity in a
fully depreciated building to process the fruit drink. The fruit drink will be discontinued in four years.
The new equipment is depreciated to zero using straight line depreciation. The new fruit drink requires
an increase in working capital of $25,000 and $5,000 of this increase is offset with accounts payable.
Projected sales are 150,000 jars of fruit drink the first year, with a 20 percent growth for the following years.
Variable costs are 55% of total revenues and fixed costs are $10,000 each year. The new equipment costs
$195,000 and has a salvage value of $25,000.
The corporate tax rate is 35 percent and the company currently has 1,000,000 shares of stock outstanding
at a current price of $15. The company also has 50,000 bonds outstanding, with a current price of $985. The
bonds pay interest semi-annually at the coupon rate is 6%. The bonds have a par value of $1,000 and will
mature in twenty years.
Even though the company has stock outstanding it is not publicly traded. Therefore, there is no publicly
available financial information. However, management believes that given the industry they
are in the most reasonable comparable publicly traded company is Cott Corporation (ticker symble
is COT). In addition, management believes the S&P 500 is a reasonable proxy for the market portfolio.
Therefore, the cost of equity is calculated using the beta from COT and the market risk premium based on the
S&P 500 annual expected rate of return. (We calculated a monthly expected return for the market
in the return exercise. You can simply multiply that rate by 12 for an expected annual rate on the
market.) The WACC is then calculated using this information and the other information provided
above. Clearly show all your calculations and sources for all parameter estimates used in the WACC.
Required
1. Calculate the WACC for the company.
2. Create a partial income statement incremental cash flows from this project in the
Blank Template worksheet using the tab below.
3. Enter formulas to calculate the NPV by finding the PV of the cash flows over the next four years.
(You can either use the EXCEL formula PV() or use mathmatical formula for PV of a lump sum.)
4. Set up the EXCEL worksheet so that you are able to change the parameters in E3 to E12.
Run three cases best, most likely, and worst case where the growth rate is 30%, 20%, and 5%,
respectfully.
5. Create a NPV profile for the most likely case scenario. (See NPV Calculation tab below.)
6. State whether the company should accept or reject the project for each case scenario.

Answer 1

Sol 1. WACC for the company can be calculated by assuming few things firstly that Current Market Price of the Shares is also its Book Price, second the Risk Premium Rate is 9.00% Risk free rate is 2.50% and Beta is 0.70 as per question direction. The total capital raised by the company is Equity= 15*1000000 shares thus $1,50,00,000 and Debt is 50000*1000= $5,00,00,000 thus total capital = $6,50,00,000 so the weightage of Debt is 0.77 or 77% of the total capital and Equity is only 0.23 or 23%. Cost of debt is calculated by taking the effective rate of interest rate as 6.09% p.a. after giving the compounding effect. The formula used for calculating cost of Debt= Effective Interest on Par Value x (1-Tax Rate) + (Par Value-Current Bond Price)/Time Maturity (20 years) this we will divide by Average of Par Value + Current Bond Price. This whole calculation will give cost of debt as 4.06% and Cost of Equity will be calculated by CAPM formula i.e. Risk Free Rate + Beta (Market Risk Rate-Risk Free Rate) which will result in Ke as 7.12% thus WACC will be calculated by multiplying Wts by Cost of Debt & Equity which will result in WACC in equity as 1.64% and WACC debt is 3.12% thus total WACC 4.77%.

Sol 2 & 3. The following is the calculation of Estimated Profit & Loss Statement and Estimated Cash Flows

Projected Income Statement
	Year 1	Year 2	Year 3	Year 4
Sales	150000	180000	216000	259200
Variable Cost	82500	99000	118800	142560
Fixed Cost	10000	10000	10000	10000
Depreciation	42500	42500	42500	42500
PBT	15000	28500	44700	64140
Tax Rate	5250	9975	15645	22449
PAT	9750	18525	29055	41691
Projected Cash Flows
Time	Cash Flows	DF @ WACC	PV
0	-215000	1.00	-2,15,000.00
1	52250	0.95	49,871.15
2	61025	0.91	55,594.77
3	71555	0.87	62,219.88
4	109191	0.83	90,623.13
NPV			43,308.92

Sol 4, 5 & 6:

NPV Calculation at Growth rate 20% is as above for Growth rate 5% and 30% are below:

Projected Income Statement
	Year 1	Year 2	Year 3	Year 4
Sales	150000	157500	165375	173644
Variable Cost	82500	86625	90956.25	95504
Fixed Cost	10000	10000	10000	10000
Depreciation	42500	42500	42500	42500
PBT	15000	18375	21918.75	25640
Tax Rate	5250	6431.25	7671.5625	8973.9
PAT	9750	11943.75	14247.1875	16666
Projected Cash Flows
Time	Cash Flows	DF @ WACC	PV
0	-215000	1.00	-2,15,000.00
1	52250	0.95	49,871.15
2	54443.75	0.91	49,599.14
3	56747.18	0.87	49,343.90
4	84166	0.83	69,853.62
NPV			3,667.80

Growth rate 30% as under

Projected Income Statement
	Year 1	Year 2	Year 3	Year 4
Sales	150000	195000	253500	329550
Variable Cost	82500	107250	139425	181253
Fixed Cost	10000	10000	10000	10000
Depreciation	42500	42500	42500	42500
PBT	15000	35250	61575	95798
Tax Rate	5250	12337.5	21551.25	33529
PAT	9750	22912.5	40023.75	62268
Projected Cash Flows
Time	Cash Flows	DF @ WACC	PV
0	-215000	1.00	-2,15,000.00
1	52250	0.95	49,871.15
2	65412.5	0.91	59,591.85
3	82523.75	0.87	71,757.64
4	129768	0.83	1,07,701.02
NPV			73,921.66

The company according to NPV should accept the project as NPV is positive otherwise also till 5% growth also NPV is positive. Thus company should say yes to this project.