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Computing the divisional cost of capital using the pure-play method

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  • Henry Collier
  • Timothy Grai
  • Steve Haslitt
  • Carl McGowan

Abstract

The cost of capital model is used to calculate the net present value (NPV) of projects within a multi-unit corporation but may provide incorrect answers for projects that have a level of risk that differs from the overall average risk level for the corporation. We demonstrate the use of the pure-play method for calculating the required rate of return for a division of a corporation that has risk characteristics that differ from the risk characteristics of the overall corporation. We apply this methodology to the Integrated Electronic Systems Segment (IESS) of the Motorola Corporation. We find that the IESS division cost of capital of is 9.3% rather than the 12.3% cost of capital for the corporation as a whole.

Suggested Citation

  • Henry Collier & Timothy Grai & Steve Haslitt & Carl McGowan, 2007. "Computing the divisional cost of capital using the pure-play method," Applied Financial Economics, Taylor & Francis Journals, vol. 17(15), pages 1227-1231.
    • Handle: RePEc:taf:apfiec:v:17:y:2007:i:15:p:1227-1231
    DOI: 10.1080/09603100600970065
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    References listed on IDEAS

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    1. Gordon, Myron J & Halpern, Paul J, 1974. "Cost of Capital for a Division of a Firm," Journal of Finance, American Finance Association, vol. 29(4), pages 1153-1163, September.
    2. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    3. Hamada, Robert S, 1969. "Portfolio Analysis, Market Equilibrium and Corporation Finance," Journal of Finance, American Finance Association, vol. 24(1), pages 13-31, March.
    4. Fuller, Russell J & Kerr, Halbert S, 1981. "Estimating the Divisional Cost of Capital: An Analysis of the Pure-Play Technique," Journal of Finance, American Finance Association, vol. 36(5), pages 997-1009, December.
    5. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
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    Cited by:

    1. Samir Harith & Ruth Helen Samujh, 2020. "Small Family Businesses: Innovation, Risk and Value," JRFM, MDPI, vol. 13(10), pages 1-15, October.

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