Net present value in corporate finance

Corporate Finance

Cascade Water has the following cost of capital. The total value of the company is apparently going to be valued using market value. Normally, you wouldn't do that but ok. The market value of common stock is $1.26 billion. The market value of the debt is $461, 695, 000, which gives the total market value of the company as $1,721,695,000. The weight of equity is therefore 73.1%, which means that the weight of the debt is 26.9%.

The weighted average cost of capital is calculated as the weight of equity multiplied by the cost of equity, plus the weight of debt multiplied by the cost of debt. The cost of debt can be determined using a yield to maturity calculator. For this to work properly, you would need to know how much time is left to maturity, but since we don't have that we'll have to kludge our way through this. The yield to maturity is 10.96%.

The cost of equity is determined using the capital asset pricing model. CAPM for Cascade Water is as follows:

Rf + ?(Rm-Rf)

3.5 + (2.639)(12.52-3.5)

= 27.3%

So the weighted average cost of capital for Cascade Water is:

(27.3)(.731) + (10.96)(.269)

19.95 + 2.95 = 22.9%

The next step is to determine what the net present value of the project is. First up, the tax credit that the project gives for the depreciation, which is going to be $1 million per year. This tax credit is a positive cash flow for the project, and is equal to the depreciation multiplied by the tax rate, which in this case is 34%. The tax credit only accrues if the company is profitable and therefore actually paying tax. We will assume this.

The choice of discount rate is also important. The pure play strategy implies that the company is evaluating the product strictly on its own, as opposed to against its normal risk characteristics. This is an interesting choice, given that the company already has a very high risk profile, with a beta of 2.6, which is higher than either of the pure play firms. Selling to children is probably riskier than adults, but also worth considering is that the company with multiple product lines is also likely to have better diversification. The pure play strategy implies that this is not the case. The company is still selling water, which ought to be the core business of a company called Cascade Water, so there is little logic to making this a pure play.

I would therefore reject categorically the idea that this is a pure play. A slightly different target market does not justify a pure play, especially given the inherent sloppiness of trying to use companies we know nothing about as corollaries in order to determine a completely different discount rate. Further, this completely different discount rate would be lower than the one based on current business, given the differences in the betas of the pure play comparables. Again, this doesn't make any sense at all -- you would not choose to estimate the risk of a brand new business at a lower rate than existing business unless a compelling argument has been made with respect to this -- and that argument has not been made. The company's WACC of 22.9% will be used as the discount rate for this project.

This gives the following NPV calculation:

Year

0

1

2

3

Outlay

-3

DepTax

340000

340000

340000

Sales

1562500

1562500

1562500

VC

-300000

-300000

-300000

FC

-200000

-200000

-200000

Terminal

500000

FV

-3

1402500

1402500

1902500

PV

$3,094,579.01

NPV

$94,579.01

As the table illustrates, the net present value of the project is $94,579, which means that if there are no better options on the table for Cascade Water, the company should accept the project. The rule of thumb is that if the project has a positive net present value, the company should accept the project because it will add value, and management should be seeking to add value.