Estimation of Cost of Capital 105the ‘pure play’ technique. Since the beta for the division is unobservable in the marketplace, a proxy beta
derived from a publicly traded firm whose operations are as same as possible to the division in question is
used as the measure of the division’s systematic risk. The pure play approach attempts to identify firms with
publicly traded securities that are solely engaged in the same line of business as the division. These compar-
able firms are called pure play firms. A firm should satisfy the following characteristics to qualify as a pure
play firm:
- The firm should have only one business line and no miscellaneous revenue.
- The pure play should be in the same industry or business line as the division in question.
- The revenues of the pure play should be roughly the same as those of the division.
- When more than one firm can be identified as a potential pure play, the firm with the median beta could
be chosen as pure play.
The important insight to be gained from the preceding discussion is that for multi-division firms WACC is
a meaningless concept. It is necessary to calculate the cost of capital for each division separately.
Survey Results
Gitman and Forrester (1977) conducted a survey of cost of capital estimation techniques in Fortune 1000
companies. The summary of their findings is shown in Exhibit 4.10. As can be seen, a majority of them use
a WACC based on target capital structure in line with theory. About 16.40 percent of them use book value
weights, which is conceptually weak.
Exhibit 4.10 Approach/weighting scheme in cost of capital estimation
Percentage of
Approach/weighting scheme 177 respondents
Use cost of specific source of financing 16.90
planned for funding the alternative
Use WACC based on book value weights 16.40
Use WACC based on target capital 41.80
structure weights
Use WACC based on current market 28.80
value weights
Some other weighting scheme 0.60
The survey also included cost of equity calculation procedure. The summary of their findings is given in
Exhibit 4.11. A majority of the companies use current market-based costs of similar obligations when measuring
cost of debt and/or preferred stock consistent with theory. About one-third of the respondents indicated the
use of historical cost of the obligation, which is inconsistent with theory. A majority of the companies revise
cost of capital estimation when environmental conditions change sufficiently to warrant it or make revisions
annually. More recently Graham and Harvey (2001) conducted a survey of practices in 392 firms in the US.
Their survey had questions on how firms estimate the cost of equity capital. Each question was to be rated on
a four-point scale. They explore whether firms use the CAPM, a multi-beta CAPM, average historical returns
or a dividend discount model. They find that CAPM is by far the most popular method. The result of their
survey is presented in Exhibit 4.12.