(177)---THE PURE PLAY TECHNIQUE

The Pure Play Technique

Calculate the division’s equity cost of capital

The asset or unlevered beta for the division is 0.67. We need to convert the asset or unlevered beta into the equity or levered beta for calculating the cost of equity for the division. To obtain the equity beta, the asset beta should be levered to reflect the target capital structure of the division. What is the target capital structure of the division? The company may use the firm’s target capital structure for the division as well. Alternatively, it may decide the division’s target capital structure based on the average debt ratio of the pure play firms.

Calculate the division’s cost of capital

The cost of capital for the division is the weighted average cost of equity and the cost of debt. It should be clear from the approach discussed here that each division has its own operating risk and debt capacity. Therefore, for calculating the cost of capital for each division, you should determine its operating risk and debt capacity. Assets of the firm are the aggregate of assets of the divisions. Therefore, the beta of assets for the firm should be the weighted average of betas for the divisions:

Firms asset beta = beta of division1 X weight of division1 + beta of division2 X weight of division2 +……………. + beta of division n X weight of division n

It seems plausible that weights may be expressed in terms of market value of assets. In practice, the market value of assets of divisions are not available, therefore, weights may be expressed in terms of book value assets or sales.