Company L is a privately held motor company. Person R, the owner of Company L 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 $197,000,000. It has expanded its operations steadily whenever it had excess profits. However, the company did not employ capital budgeting techniques. Therefore, Person R has hired Person X to determine the cost of capital of Company L. As Company L is a private company, it is difficult to determine the cost of equity . Hence, Person R suggests the use of pure play approach to determine the cost of capital. He wants Person X to refer the financials of Company T to determine its cost of capital. Characters in the case: Company L: The character attempting to determine an appropriate cost of capital Person R: The founder of Company S Person X: The analyst hired by Company S Company T: A pure play company To determine: The drawbacks of pure play approach. 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.

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Chapter 12, Problem 5CC

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Case summary:

Company L is a privately held motor company. Person R, the owner of Company L 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 $197,000,000. It has expanded its operations steadily whenever it had excess profits.

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

Characters in the case:

Company L: The character attempting to determine an appropriate cost of capital

Person R: The founder of Company S

Person X: The analyst hired by Company S

Company T: A pure play company

To determine: The drawbacks of pure play approach.

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.

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Scenario one: Under what circumstances would it be appropriate for a firm to use different cost of capital for its different operating divisions? If the overall firm WACC was used as the hurdle rate for all divisions, would the riskier division or the more conservative divisions tend to get most of the investment projects? Why? If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division’s cost of capital?

Scenario three: If a portfolio has a positive investment in every asset, can the expected return on a portfolio be greater than that of every asset in the portfolio? Can it be less than that of every asset in the portfolio? If you answer yes to one of both of these questions, explain and give an example for your answer(s). Please Provide a Reference

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