Pure Play Technique of Determining the Divisional Cost of Capital

The Pure Play Technique is a frequently used method of determining the cost of a divisional project. It involves the following major steps −

Identifying Comparable Firms

The first step in the Pure Play Method is to find identical firms with similar features. In the real world, it is impossible to find exactly similar firms, as even the most resembling firms have different features. However, it is not impossible to find two or three firms that have quite similar features, and hence finding two to three firms with similar features (not exactly similar) is sufficient for the process.

If no matches are found, the average data of a broader sample of firms should be used.

Estimating Equity Betas of Comparable Firms

Once the matching firms have been identified, the next step is to calculate the equity betas of the firms by using the CAPM framework and a market index such as Sensex. We can use the betas from the Bombay Stock Exchange (BSE) or National Stock Exchange (NSE). These betas are based on share price and market index data, and so they are equity betas for the firms.

Estimating Asset Betas for Comparable Firms

The companies usually employ both equity and debt as the assets and hence, comparing asset betas of equivalent firms is also required to use the pure-play technique. The equity betas are often affected by their debt structures. Also, the firms may have a different structure than the equity betas of comparable firms. Therefore, the proxy betas need to be converted to equity betas in the pure-play technique.

Calculating the Division’s Beta

We can use the asset beta of the pure-play firms as a proxy for the asset beta. Either a simple or weighted average can be used for the purpose. For the firm's weights, we can use either "sales" or "assets" of the company. The theory does not provide any clue whether sales or assets data should be used for the purpose and the analysts should use their own judgment for the purpose.

Calculate the Division’s All-Equity Cost of Capital

The all-equity cost of capital should be derived from risk-free rate and market risk premium. The all-equity or the cost of capital is completely risk-free. It is also called the asset or unlevered cost of capital.

Calculating the Firm's Equity Cost of Capital

When the asset or unlevered beta of a company is known, it can be converted to equity or levered beta. To get the levered beta, the asset beta should be re-levered to show the target capital structure of the firm.

Calculate the Division’s Cost of Capital

The cost of capital for the division is the weighted average of the cost of equity and cost of debt. The weighted cost of capital can be calculated now using the cost of debt and tax rate.