Sunday, April 25, 2010


The Pure Play Technique

Estimate asset beta for comparable firms

The comparable firms also employ debt to finance their assets. The equity betas of these firms are affected by their debt ratios. The firm may have a different target capital structure that the debt ratio of the proxy firms. Therefore, the pure play technique requires that the leverage equity betas of the proxy firms should be changed to unlevered or all-equity beta. Unlevered or all-equity betas are also called asset betas.

If we consider that debt is risk free, then Bd is zero, and we can find unlevered beta as follows:

Bu = B1 (E/V) = B1 (1- D/V)

Where Bu is the beta of the pure play firm after removing the effect or leverage: B1 is its equity beta with leverage: and E/V is the ratio of the pure play firm’s equity to its total market value. Note above equation is based on two important assumptions.
  1. That debt is risk free and hence the beta foe debt is zero
  2. All pure play firms maintain target capital structure and therefore, the amounts of debt change with the change in the values of firms.

The unlevered or all-equity beta is also called the asset beta as it incorporates only the firm’s operating risk and is not influenced by the financial risk arising from the use of debt.

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