Cascade Water Company (CWC) currently has 30,000,000 shares of common stock outstanding that trade at a price of $42 per share. CWC also has 500,000 bonds outstanding that currently trade at $923.38 each. CWC has no preferred stock outstanding and the beta of its common stock is 2.639. The risk-free rate is 3% and the required return on the market is 12.5%. The firm's bonds have 20 years to maturity, a $1,000 par value, a 10% annual coupon rate with semiannual coupons.
CWC is considering adding to its product mix a healthy bottled water geared toward children. The initial outlay for the project is expected to be $3,000,000 which will be depreciated 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 $1.25 per unit. Variable costs are estimated to be $0.24 per unit, and fixed costs of the project are estimated at $200,000 per year. The project is expected to have a 3-year life and a terminal value (excluding the operating cash flows for year 3) of $500,000. CWC has a 34% tax rate. For purposes of this project, working capital effects will be ignored. Bottled water targeted at children is expected to have different risk characteristics from the firm's current products. Therefore, CWC has decided to look for other firms with products similar to the proposed project.They have identified the following two firms and their common stock betas.
Firm Beta
Fruity Water 1.72
Ladybug Drinks 1.84
Assignment
1. What are the expected cash flows for the healthy water project?
2. Should CWC under take the healthy water project? Support your conclusion.