Using the WACC as discount rate is only appropriate for projects that have the same risk as the

firm’s current operationsIf we are looking at a project that has NOT the same risk as the firm, then
the appropriate discount rate for that project has to be determined Divisions also often require
separate discount rates because they have different levels of risk
Theory stipulates that for a multidivisional firm, if the risk of divisional cash flows is different from the
firm's cash flows, then the appropriate discount rate for an investment decision at the division level
should reflect the riskiness of the divisional cash flows rather than that of the firm's cash flows. But
because there is no way to know the market values of divisions, estimating divisional costs of capital
has been a challenge.
The pure-play approach restricts its information set to firms engaged in only one line of business and
ignores the information contained in multidivisional firms. 
Suppose there are three firms P, Q and R, which closely resemble project X that is to be
embarked upon. The stock Betas of the three firms are taken and found to be 2.73, 2.23 and
1.73 respectively for P, Q and R. The Ratio of Debt to Equity for the three firms averages to
0.67. The marginal tax rate is 36%. The average stock Beta works out to 2.23. Translating these
into the Hamada formula for unlevered firms we get: BU=BL/(1+(1-T)(D/S)) =2.23/(I+0.64)
(0.67)=1.56 This suggests that on an all-equity basis the Beta of the project would be 1.56.
Now, if the project is proposed to be financed by 50% equity and 50% debt, we

firms with abundant access to capital but limited qualified management or

manpower appear to forgo profitable projects in preparation for more profitable
future investment opportunities. Consistent with this explanation, firms that use
high discount rates have strong balance sheets, low leverage, and large cash
holdings. In addition, firms appear to increase discount rates to account for
idiosyncratic/unsystematic risk.
In capital budgeting, most firms use discount rates that exceed their cost of
financial capital by a wide margin.

1. The Hamada formula is based on Modigliani and Miller’s formulation of the tax shield values
for constant debt, i.e. when the dollar amount of debt is constant over time. The formulas
are not correct if the firm follows a constant leverage policy, i.e. the firm rebalances its
capital structure so that debt capital remains at a constant percentage of equity capital,
which is a more common and realistic assumption than a fixed dollar debt (Brealey, Myers,
Allen, 2010). If the firm is assumed to rebalance its debt-to-equity ratio continuously, the
Hamada equation is replaced with the Harris-Pringle equation; if the firm rebalances only
periodically, such as once a year, the Miles-Ezzell equation is the one to be used.
2. The discount rate used to calculate the tax shield is assumed to be equal to the cost of debt
capital (thus, the tax shield has the same risk as debt). This and the constant debt
assumption in (1) imply that the tax shield is proportionate to the market value of debt: Tax
Shield = T×D.
It came out with a theory that the capital structure is irrelevant for
deriving the cost of capital. The impact is limited to the extent of
taxation effect. Thereby, if we ignore taxes, the value of the firm and
the cost of capital will not be affected by the variations in the capital
structure. That means the decision on capital structure is immaterial
because the equity-debt mix does not affect the overall value of the
firm. The present value of future earnings and its underlying assets
determines the market value of the firm and not the capital structure.

Once we have determined the set of comparable firms, we need to find the levered beta
The pure-play approach consists of finding a company listed in the stock market which activity is
the same as that of the division/project of a firm being valued. By calculating the beta of this
pure-play company, the CAPM can be applied to estimate the cost of equity of the division
under analysis.
The methodology is based on the principle that betas are additive; that is, the beta for a
company is simply the weighted average of the betas of each division, as shown by the
following formula: βi = ∑wij × β
The method is a two-step process – in the first step, the betas of each company are estimated,
while in the second, the divisional betas are predicted by the formula above.
The necessary data for the estimation of the divisional betas are market returns for the
companies listed and market returns for the business segments
There is the problem of data availability for the market value for each division
Another advantage of using the multiple-play approach, when applicable, is that by not
restricting the sample to pure-play companies the problem of sample size is eliminated and,
consequently, the estimates can be more accurate.