Chapter 12, Problem 5CC

Summary Introduction

Case summary:

Company H is a privately held motor company. Person B, the owner of Company H invented the method of manufacturing battery for electric cars at a cheaper rate with a higher mileage. His company gained popularity and competed with other auto manufacturers. The previous year’s sales were $97,000,000. It has expanded its operations steadily whenever it had excess profits.

However, the company did not employ capital budgeting techniques. Therefore, Person B has hired Person X to determine the cost of capital of Company H. As Company H is a private company, it is not easy to determine the cost of equity. Hence, Person B suggests the use of pure play approach to determine the cost of capital. He wants Person X to refer the financials of Company D to determine its cost of capital.

Characters in the case:

• Company H: The character attempting to determine an appropriate cost of capital
• Person B: The founder of Company S
• Person X: The analyst hired by Company S
• Company D: A pure play company

Introduction:

The pure play approach refers to the use of the weighted average cost of capital (WACC) for calculating the net present value based on the cost of capital of other companies in the market running operations similar to that of the proposed project.

To determine: The drawbacks of pure play approach