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Chapter 12 - Web Appendix 12D

Chapter 12 - Web Appendix 12D - WEB APPENDIX 12D Techniques...

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WEB APPENDIX 12D Techniques for Measuring Beta Risk In Chapter 8, we discussed the estimation of betas for stocks and we indicated the difficulties encountered in estimating beta. Estimating project betas is even more difficult and more fraught with uncertainty. However, two approaches have been used to estimate individual assets betas the pure-play method and the accounting beta method. The Pure-Play Method In the pure-play method , the company finds several single-product companies in the same line of business as the project being evaluated and averages those companies betas to determine the cost of capital for its own project. For example, suppose Erie (discussed in Web Appendix 12C) found three existing single- product firms that operate barges. Also suppose that Erie s management believes its barge project would be subject to the same risks as those three firms. Erie could then determine the betas of those firms, average them, and use the average beta as a proxy for the barge project s beta. 1 The pure-play approach can be used only for major assets such as whole divisions, and even then the method is frequently difficult to implement because pure-play proxy firms are almost impossible to find. However, when IBM was
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