Question 6: Cost of Capital (60 points)

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.

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