Question

You are computing the discount rate for a project in the furniture business. Your firm is 100% equity financed and will remain that way. There are three publicly traded firms that are in the furniture business and are not involved in any other lines of business. However, only one of these three firms is 100% equity financed. You should only use the 100% equity-financed "pure play" for your calculations because the equity betas of the other two pure plays are higher than their respective asset betas due to the presence of debt. Is the statement in italics correct?

Answer 1

Answer:

The given statement is correct

Explanation:

A well-perceived strategy to measure the cost of the capital for a project is 'pure-play'. As indicated by pure-play procedure, a firm faces two kinds of risks, the most significant is financial leverage risk as beta increases due to an increase in financial leverage risk and the second type is an operational risk. If a firm is persuaded to apply the pure-play method for the calculation of the cost of capital, for that, they should utilize the unlevered beta for the organization that is working in the same industry. Therefore, according to this technique, the given explanation is right.