(173)---THE PURE PLAY TECHNIQUE

The Pure Play Technique

Suppose XYZ Company limited has three divisions: pharmaceutical division, financial services division and power generation division. The company’s cost of capital is 12%. Since the company has three diverse businesses with different operating characteristics, it cannot use its overall cost of capital as the required rate of return for its divisions. It should estimate the required rate of return for each division separately. Suppose XYZ Company limited is considering an investment in the pharmaceutical division, and therefore, it would like to estimate the required rate of return for each division. A most commonly suggested method for calculating the required rate of return for a division (or project) is the pure play technique. The basic idea is to use the beta of the comparable firms, called pure play firms, in the same industry or line of business as a proxy for the beta of the division or the project. The application of the pure play approach for calculating the pharmaceuticals division’s cost of capital will involve the following steps:

1. Identify comparable firms
2. Estimate equity betas for comparable firms
3. Estimate asset betas for comparable firms
4. Calculating the division’s beta
5. Calculating the division’s all equity cost of capital
6. Calculating the division’s equity cost of capital
7. Calculate the division’s cost of capital