Calculating Beta using Pure Play Method

Can someone please explain the following in detail in simple words so that i can get a clarity on the following concepts:- 1. What is Beta? 2. What is project beta? Why is it calculated? 3. Why is the beta of comparable company ascertained (in pure play method)? 3. What is meant by unlevering the beta and levering the beta(in pure play method)? Thanks.

It’s the sensitivity of the returns on the company’s common stock to changes in the return on the market.

It’s the sensitivity of the returns on the project to changes in the return on the market.

It’s calculated as an intermediate step in determining the company’s stock’s beta, so that a model such as CAPM can be used to determine the required return on common equity.

Because the returns on that company’s common stock are determined solely by the returns on projects of the type that your company is considering undertaking. Therefore, it’s easy to determine the sensitivity of returns on that type of project from that company’s stock returns.

The change in the return on a company’s stock is not the same as the change in the return on a company’s assets (because of leverage). Unlevering the beta of the pure-play company’s stock gives you the beta of the pure-play company’s assets, which we assume will be the beta of our company’s assets devoted to the same type of project. Levering that beta for our company gives us the beta for our company’s stock (issued to finance this project), which is used to determine the required rate of return for that stock issue (which is then used to calculate the WACC for that project).

My pleasure.

This is why I love AF. Thank you Mr. Campbell.

S2000,

I came across this thread and would like to share my thought process and add a few questions along the way:

  1. A company is thinking about engaging in a project and is trying to determined the discount rate for that project (i.e. project beta)

  2. To get the project beta, the pure-play method can be used. This method calls for getting the equity beta of a company that is engaged in a comparable business to the project we are thinking of engaging in.

  3. We take the comparable firm’s equity beta, but unlever it because the equity beta takes into account the comparable beta. This is wrong because we need to look at OUR firm’s financial risk/capital structure, not theirs.

  4. Thus, we relever the asset beta using our firm’s D/E and marginal tax rate. This calculation gives us our firm’s equity beta…

  5. We calculate the WACC by using the cost of equity (one way of calculating cost of equity is through CAPM) and the weights of the firm’s sources of capital.

When calculating the Cost of Equity using CAPM, do we use the Equity beta or the Project Beta? In step 4, which beta are we calculating? Isn’t the firm beta a measure of the riskiness of an AVERAGE project to the market returns? So shouldn’t we be adjusting the equity beta in step 4 for the project risk (assuming the equity beta in step 4 is the FIRM beta)?

Thanks.

Beta is not a discount rate. Be careful here. Beta is used in the CAPM formula to get the required rate of return on common equity, which goes into the discount rate.

Correct. The idea is that comparable projects should have comparable betas.

I don’t know why you think that this is wrong. The pure play company’s equity beta and its project (asset) beta are related by the company’s leverage. We can easily observe the company’s equity beta (we can go to Yahoo! finance and get the returns on the company’s common stock and the returns on the market). To get the asset beta, we unlever the company’s equity beta.

Why do you think that this is wrong?

Yup.

Yup.

We’re valuing equity, so we use the equity beta. In step 4 we get the equity beta from the project beta by levering it.

Yes, the firm’s equity beta should be the levered value of the weighted average project beta. That’s, fortunately, beyond the scope of the CFA curriculum.

You’re quite welcome. I hope that I helped, at least a bit.

When I said it was wrong, I meant that it was inappropriate to look at the equity beta of a comparable company. Instead, we should unlever the other firm’s beta (i.e. calculate asset beta) and then lever it using our capital structure. Therefore, this new equity beta is appropriate because it reflects our capital structure and the business risk of our project. So the word “wrong” meant “inappropriate” when analyzing a possible project.

In regards to my bolded question and your answer - just to clarify:

  1. Equity beta can be referred to as the project risk (i.e. project equity beta) and the overall firm beta (i.e. firm equity beta).

  2. When using the CAPM to calculate the cost of equity, we use any of the two equity betas depending on the purpose of analysis.

So when is it appropriate to use the firm equity beta versus the project equity beta? If we are trying to determine the required return on common equity for a project, we use the project equity beta in CAPM.

If we are assessing the average risk of a project, we simply use the firm beta?

Thanks again!