University:
Duke University
Course:
ECON 370 | Global Capital Markets
Academic year:

2019
Views:

95

Pages:

7
Author:

Maverick Martin

14.5 Divisional and Project Costs of Capital THE SML AND THE WACC The Weighted Average Cost of Capital (WACC) represents the overall cost of capital for a firm, reflecting its typical risk level. However, when evaluating projects or investments that have risks significantly different from the firm’s average risk profile, using the WACC can lead to in This example highlights that, for an all-equity firm with average market risk, the WACC and cost of equity are the same. However, if a firm with this profile evaluates a project with substantially higher or lower risk than the overall company, using the same WACC (15%) would be inappropriate. Correct decisions. The Security Market Line (SML) and the Weighted Average Cost of Capital (WACC) For example, consider point A. This project has a beta of βA = .60, as compared to the firm’s beta of 1.0. It has an expected return of 14 percent. Is this a desirable investment? The answer is yes because its required return is only: THE PURE PLAY APPROACH  Pure Play Approach:The pure play approach is used to estimate the required return on an investment by analyzing market-required returns from companies that focus exclusively on a single line of business.  A company focusing on one business type is called a "pure play." For example, if you want to invest in crude oil price movements, you would look for companies that deal exclusively in crude oil, as they are the most sensitive to price changes.  This method helps in estimating the cost of capital for a new business venture by comparing it to companies already operating in that space. For example, if McDonald's entered the computer business, it would Identifying Comparable Companies:  To calculate an appropriate cost of capital, it’s important to identify companies that closely resemble the project or line of business being evaluated.  The goal is to find companies whose business risks align with the project or new business venture. For example, McDonald's would look to Dell, a computer company, rather than HP, which has multiple product lines.  The more closely a company focuses on the desired business, the more reliable the estimate of cost of capital will be. Challenges with the Pure Play Approach:  Finding an appropriate "pure play" company for comparison can be difficult. Sometimes, there are no companies that match the exact business model or project, making it hard to estimate a discount rate objectively.  The key issue is ensuring that mistakes are minimized when using the weighted average cost of capital (WACC) as a blanket cutoff for all investments, which may lead to inaccurate decisions without considering the unique risks of different ventures.