Makita Inc. is a tool company. Recently, its stock has been added to the list of over-the-counter stocks traded in the U.S. Its equity beta is estimated to be 1.70.

 Makita is considering investing in a kitchen appliance business. The business project will require an initial investment of $400,000. If accepted, the kitchen appliance business will represent 10% of Makita's assets.

 There is a 40% chance the project will generate an annual payoff of $120,000 forever, a 40% chance of an annual payoff of $80,000 forever, and a 20% chance that the project will be a complete flop and generate no cash. (Assume these are after-tax cash flows.)

A firm investing solely in the kitchen appliance business (pure play) has an equity beta of 1.23. Suppose the pure play company has 50% debt and 50% equity.

 Makita currently has 40% debt and 60% equity, and will maintain the same capture structure for the new kitchen appliance business.

 Makita forecasts that the return on the market portfolio (Rm) will be 14% and the Treasury bill rate (Rf) will be 8%. Suppose both Makita and the pure play company hold risk-free debts. The corporate tax rate is 40%.

 

a. What is Makita's overall cost of capital (WACC) before taking the project?

b. What is the internal rate of return (IRR) of the kitchen appliance project? (Hint: IRR is the discount rate that sets NPV equal zero)

c. What is the appropriate cost of capital for the kitchen appliance project?

Based on your answers to part b and part c, should Makita accept the kitchen appliance project? Why?

What is Makita's overall cost of capital after taking the kitchen appliance business?