The Pure Play Approach

We've seen that using the firm's WACC inappropriately can lead to problems. How can we come up with the appropriate discount rates in such circumstances? Because we cannot observe the returns on these investments, there generally is no direct way of coming up with a beta, for example. Instead, what we must do is examine other investments outside the firm that are in the same risk class as the one we are considering and use the market-required returns on these investments as the discount rate. In other words, we will try to determine what the cost of capital is for such investments by trying to locate some similar investments in the marketplace.

For example, going back to our telephone division, suppose we wanted to come up with a discount rate to use for that division. What we could do is identify several other phone companies that have publicly traded securities. We might find that a typical phone company has a beta of .80, AA-rated debt, and a capital structure that is about 50 percent debt and 50 percent equity. Using this information, we could develop a WACC for a typical phone company and use this as our discount rate.

Alternatively, if we were thinking of entering a new line of business, we would try to develop the appropriate cost of capital by looking at the market-required returns on companies already in that business. In the language of Wall Street, a company that focuses on a single line of business is called a pure play. For example, if you wanted to bet on the price of crude oil by purchasing common stocks, you would try to identify companies that dealt exclusively with this product because they would be the most affected by changes in the price of crude oil. Such companies would be called pure plays on the price of crude oil.

What we try to do here is to find companies that focus as exclusively as possible on the type of project in which we are interested. Our approach, therefore, is called the pure play approach to estimating the required return on an investment. To illustrate, suppose McDonald's decides to enter the personal computer and network server business with a line of machines called McPuters. The risks involved are quite different from those in the pure play approach

The use of a WACC that is unique to a particular project, based on companies in similar lines of business.

Ross et al.: Fundamentals I VI. Cost of Capital and I 15. Cost of Capital I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Companies, 2002

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512 PART SIX Cost of Capital and Long-Term Financial Policy fast-food business. As a result, McDonald's would need to look at companies already in the personal computer business to compute a cost of capital for the new division. Two obvious "pure play" candidates would be Dell and Gateway, which are predominately in this line of business. IBM, on the other hand, would not be as good a choice because its primary focus is elsewhere, and it has many different product lines.

In Chapter 3, we discussed the subject of identifying similar companies for comparison purposes. The same problems we described there come up here. The most obvious one is that we may not be able to find any suitable companies. In this case, how to objectively determine a discount rate becomes a very difficult question. Even so, the important thing is to be aware of the issue so that we at least reduce the possibility of the kinds of mistakes that can arise when the WACC is used as a cutoff on all investments.

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