What is meant by a pure-equity firm?

Banking & FinanceFinance ManagementGrowth & Empowerment

A pure-equity or an unlevered firm obtains all its funds internally and does not require to obtain any debt from the market. In other words, pure-equity firms are debt-free. Therefore, in case of an investment, a pure-equity firm doesn’t have to pay any interest for the debt the company may acquire from the market.

  • Debt-free companies may use retained earnings or revenues generated from their existing projects to fund an investment project, so they do not need to acquire financing externally.

  • Pure-equity firms use the asset cost of capital instead of the cost of equity to fund their investment projects. It is therefore implied that the pure-equity companies rely on internal funding or funding from internal resources for the completion of a project. Pure-equity firms are therefore companies that have enough financial slack to fund new projects.

Unlevered Beta

Unlevered beta is essentially related to the risk of the company's assets. It removes the effects of using the financial leverage that is apparent in isolating the risk associated with the assets of a company. Therefore, the beta for a pure-equity firm takes care of business risk and should not include any other financial risks pertinent to the operation of the company.

  • Unlevered beta is applicable when a firm makes only equity financing and does not resort to debt financing for its projects.

  • It is also called asset beta because it counts the estimated volatility of the security and the underlying firm.

Levered Beta Vs Unlevered Beta

Levered beta changes with the gradual changes of debt used in financing a project. On the other hand, since unlevered beta does not include debt or is applicable to only equity financing, it does not have to take debt into consideration.

In case of unlevered beta, one can assume that the financing of a company is completely done with equity financing and hence all cash flows of the firm belong to the equity holders. The contribution of equity to its risk profile is relevant to the removal of the debt component from levered beta.

To get the unlevered beta, the levered beta is divided by [1 plus the product of (1 minus the tax rate) and the company's debt-equity ratio]. That is,

$$\mathrm{Unlevered\: Beta = \frac{Levered\: Beta}{[1+(1-Tax Rate)\times(Debt\: to\: Equity \:Ratio)]}}$$

raja
Updated on 11-Jan-2022 08:14:02

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