$9-16$: Central Mechanical has opened a new business unit that manufactures portable

classrooms for schools and office space for construction sites. The company's original business

has a $9\%$ cost of capital. It now wishes to estimate the cost of capital for its new business unit.

Below is data the company's financial analyst gathered on other companies that also

manufacture portable classroom and office space.

Ten$-$year government bonds yield $3\mathrm{.}05\%,$ and the market risk premium is $5\mathrm{.}5\%.$ Bankers

advised Central Mechanical that borrowing costs would be $7\%$ on the new business. Other

factors of note are that Central Mechanical is a private company, and its shares are not easily

bought and sold, and while the long$-$term demand for portables seems good, current economic

conditions are currently making investors more risk averse.

a$.$ Estimate the divisional cost of capital using the CAPM and cost of debt plus subjective

risk premium methods. You will want to add between $1\%$ and $3\%$ to your answer due to

the lack of liquidity in the company's shares.

b$.$ Independent of part a$,$ should you accept a project for the new business unit based on

an expected rate of return of $12\mathrm{.}5\%,$ given the company's cost of capital on its existing

business is $9\%$ and is $14\mathrm{.}10\%$ for the new business unit. No calculations are needed,

just explain.