Introduction to Corporate Finance

11: Risk and Capital Budgeting

cash flows and other calculations, Yanis confirmed that the NPV was $3 million. In the process

of investigating all aspects of the project and its cash flows, Yanis learned that, were the new

product to be successful, it would open the door to a number of opportunities to further expand

the company’s product line. Using option valuation techniques that he learned in an advanced

finance course, he estimated the value of these expansion options to be $0.7 million.

a Based on Yanis’ analysis, what is the value of the proposed new product investment?

b How could Yanis explain the value found in part (a) to the CFO, who is unfamiliar with the

concept of real options?

P11-11 Tech Industries, a contract manufacturer of circuit boards, is evaluating an investment in a new
production line to handle the growing demand from its customers, who produce consumer electronic
products. Based on reasonable growth assumptions, the NPV of the new production line was found
to be –$2.3 million. Therefore, management feels obliged to reject the project. It recognises that the
production line would provide a high degree of output flexibility because it could be repurposed
easily and inexpensively to produce circuit boards for numerous other applications. The company’s
project analyst estimated the value of this output flexibility option to be $3.3 million.
a Based on the information provided, what is the true value of Tech Industries’ proposed new
production line?
b What recommendation would you give Tech Industries regarding the proposed new
production line? Explain.

mini case

Cascade Water Company (CWC) currently has 30,000,000

shares of ordinary shares outstanding that trade at a

price of $42 per share. CWC also has 5,000,000 bonds

outstanding that currently trade at $92.34 each. CWC

has no preferred shares outstanding and has an equity

beta of 2.639. The risk-free rate is 3.5%, and the market is

expected to return 12.52%. The company’s bonds have a

20-year life, a $100 face value, a 10% coupon rate and pay

interest semiannually.

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 three-year life and a terminal value

(excluding the operating cash flows in year 3) of $500,000.

CWC has a 34% tax rate. (For the purposes of this project,

working capital effects will be ignored.) Bottled water

targeted at children is expected to have different risk

characteristics from the company’s current products.

Therefore, CWC has decided to use the ‘pure play’

approach to evaluate this project. After researching the

market, CWC managed to find two pure play companies.

The specifics for those two companies are as follows.

Company Equity beta D/E Tax rate

Fruity Water 1.72 0.43 34%

Ladybug Drinks 1.84 0.35 36%

ASSIGNMENT

1 Determine the current weighted average cost of capital

for CWC.

2 Determine the appropriate discount rate for the healthy

bottled water project.

3 Should the company undertake the healthy bottled water

project? As part of your analysis, include a sensitivity

analysis for sales price, variable costs, fixed costs and

unit sales at ±10%, 20% and 30% from the base case.

Also perform an analysis of the following two scenarios:

a Best case: Selling 2,500,000 units at a price of $1.24

per unit, with variable production costs of $0.22 per

unit.

b Worst case: Selling 950,000 units at a price of $1.32

per unit, with variable production costs of $0.27 per

unit.

COST OF CAPITAL AND PROJECT RISK