Divisional Cost of Capital

Central Mechanical has opened a new business unit that manufactures portable classrooms for schools and office space for construction sites. The companys 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 companys financial analyst gathered on other companies that also manufacture portable classroom and office space. New business unit comparables Beta Company A 1.35 Company B 1.45 Company C 1.10

Ten-year government bonds yield 3.05%, and the market risk premium is 5.5%. 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 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%3% to your answer due to the lack of liquidity in the companys shares.

b. Independent of part a, should you accept a project for the new business unit based on an expected rate of return of 12.5%, given the companys cost of capital on its existing business is 9% and is 14.10% for the new business unit? No calculations are needed, just explain.

A. Divisional cost of capital = %

B. The company (should or should not) accept the project for the new business unit.