Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

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

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 Makitas 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?

d) Based on your answers to part b and part c, should Makita accept the kitchen appliance

project? Why?

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

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

School Finance A Policy Perspective

Authors: Allan Odden, Lawrence Picus

5th Edition

0078110289, 978-0078110283

More Books

Students also viewed these Finance questions

Question

Complete this chemical reaction. +

Answered: 1 week ago