Question

Which one of the following examples is a correct application of the 'Pure Play' approach to estimate divisional WACCs?

a Sally's Salons owns a makeup subsidiary, which is called Mari's Makeup. Mari's Makeup is compared to MAC cosmetics, a large cosmetic company, to estimate its divisional WACC, as Mari's Makeup is within the makeup (cosmetics) industry rather than the retail (nail salons) industry.

b  

John's Trucks is compared to Arthur's Aviation to estimate the WACC of John's Trucks. This was done because John's Trucks is privately traded, and Arthur's Aviation is public, and both are within the transportation industries.

c   Fake Book's WACC was hard to compute as their internal data had apparently been hacked by KGB spies, so instead the WACC of another large technology firm, MICROSHIFT, was used. d T-Mobile's WACC was found to be 12.3. We are interested in valuing AT&T, and know that the business' are almost identical in purpose, technology and but feel that AT&T is slightly less risky for various reasons, so we subjectively estimate AT&T's WACC to be 11.3%.

Answer 1

In Pure Play method, the divisional WACC is estimated by finding the beta of companies in similar business. Then the unlevered beta for that business sector is derived and then again the unlevered beta is levered with the Capital structure of the company . After that the WACC of the division is recalculated. This is done to reflect the different financial risks that companies in a same business segment have , though they will have similar business risk.

In example a, the Mak company's WACC is compared for estimating the WACC of Mari's Make up. However , no consideration is made for ungearing and re-gearing of the equity beta to adjust the WACC to include the difference of finacial risk. So this is not a correct pure play approach.

In example b. Aviation company is compared with a Truck which are different business altogether. So this is not a pure play approach.

In example c. again the two Technology company's WACC being compared but no consideration for adjusting for financial risk difference is done. So this is not a pure play approach.

In example d. T Mobile * AT& T are in the same business and AT &T is slightly less risky as per analysis. So the WACC of T Mobile has been reduced to incorporate the difference in financial risk. This is a correct example of Pure Play approach for divisional WACC as the financial risk factor has been incorporated in WACC though the WACC of company from same business segment has been considered.