Tuesday, April 27, 2010


The Pure Play Technique

Calculate the division’s beta

We can use the average asset beta of the pure play firms as a proxy for the asset beta. We can use either simple or the weighted average. We can use either sales or assets or the value of the firms as weights. The theory does not tell us whether we should use simple or weighted average and what should be the weights. In practice, financial analysts will have to use their judgment. We think that since there is no theory and since we do not know the nature of measurement error, a simple average will do a good job.

Calculate the division’s all equity cost of capital

Suppose that the risk free rate is 6% and the market premium is 9%.

Ka = rf + risk + Premium X Ba

Ka = 0.06 + 0.09 X 0.67 = 0.12 or 12%

The all equity cost of capital is without financial risk. As it reflects only the business risk, it is also referred to as the asset or unlevered cost of capital.

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