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

Beta generally defines the riskiness in the Expected Return from a certain equity stock / company after taking into account the capital structure. A company with higher debt is considered as a risky comapny and will have a higher beta.

If we want to take Beta as an average or from a particular competitor and we need it to be a replica of the industry then generally an average is preferred. However every company has a different capital structure. So in order to normalise that debt structure and get betas according to our requirement we can use the concept of Deleveraging and Re leveraging the betas, which will allow us to calculate the betas according to our capital structure and normalise then.

However only taking a reference of the company which has the same capital structure would be a good option too.

Therefore the Above Statement is : Correct.