Unlevered Beta

4 Key excerpts on "Unlevered Beta"

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  eBook - ePub

  Cost of Capital

  Applications and Examples

  • Shannon P. Pratt, Roger J. Grabowski(Authors)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Levered betas incorporate two risk factors that bear on systematic risk: business (or operating) risk and financial (or capital structure) risk. Removing the effect of financial leverage (i.e., unlevering the beta) leaves the effect of business risk only. The Unlevered Beta is often called an asset beta. Asset beta is the beta that would be expected were the company financed only with equity capital. When a firm's beta estimate is measured based on observed historical total returns (as most beta estimates are), its measurement necessarily includes volatility related to the company's financial risk. In particular, the equity of companies with higher levels of debt is riskier than the equity of companies with less leverage (all else being equal).

  If the leverage of the division, reporting unit, or closely held company subject to valuation differs significantly from the leverage of the guideline public companies selected for analysis, or if the debt levels of the guideline public companies differ significantly from one another, it typically is desirable to remove the effect that leverage has on the betas before using them as a proxy to estimate the beta of the subject company.

  This adjustment for leverage differences is performed in three steps:

  1. Step 1: Compute an Unlevered Beta for each of the guideline public companies. An Unlevered Beta is the beta a company would have if it had no debt.
  2. Step 2: Decide where the risk would fall for the subject company relative to the guideline companies, assuming all had 100% equity capital structures.
  3. Step 3: Lever the beta for the subject company based on one or more assumed capital structures (i.e., relever the beta).

  The result will be a market-derived beta specifically adjusted for the degree of financial leverage of the subject company.

  If the levered beta is used to estimate the market value of a company on a controlling basis, and if it is anticipated that the actual capital structure will be adjusted to the proportions of debt and equity in the assumed capital structure, then only one assumed capital structure is necessary. However, if the amount of debt in the subject capital structure will not be adjusted, an iterative process may be required. The initial assumed capital structure for the subject will influence the cost of equity, which will, in turn, influence the relative proportions of debt and equity at market value. It may be necessary to try several assumed capital structures until one of them produces an estimate of equity value that actually results in the assumed capital structure. We discuss the iterative process in Chapter 21

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  eBook - PDF

  Corporate Finance

  Economic Foundations and Financial Modeling

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton, Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  This is because this methodology implicitly assumes that the stock’s price is more stable than it really is. As a result, the required return on equity will be understated. In these cases, a practical alternative is to base the beta estimate on the betas of comparable companies that are publicly traded. A comparable company, also called a peer company, is a company that has similar business risk. A comparable, or peer, company can be identified by using an industry classification system, such as the MSCI/Standard & Poor’s Global Industry Classification Standard (GICS) or the FTSE Industry Classification Benchmark (ICB). The analyst can then indirectly estimate the beta on the basis of the betas of the peer companies. Because financial leverage can affect beta, an adjustment must be made if the peer company has a substantially different capital structure. First, the peer company’s beta must be unlevered to estimate the beta of the assets—reflecting only the systematic risk arising from the fundamentals of the industry. Then, the Unlevered Beta, often referred to as the asset beta because it reflects the business risk of the assets, must be re-levered to reflect the capital structure of the company in question. Chapter 7 Cost of Capital: Foundational Topics 233 Let β E be the equity beta of the peer company before removing the effects of leverage. Assuming the debt of the peer company is of high quality—so that the debt’s beta, or β D , is approximately equal to zero (that is, it is assumed to have no market risk)—analysts can use the following expression to unlever the beta: β U ¼ β E 1 1 þ ð1  t Þ D E " # , (8) where β U is the Unlevered Beta, t is the marginal tax rate of the peer company, and D and E are the market values of debt and equity, respectively, of the peer company.

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  Applied Corporate Finance

  • Aswath Damodaran(Author)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  Cost of Equity 123 The resulting number is sometimes called a pure play beta , indicating that it measures the risk of only the business and not any other corporate holdings. 3. To calculate the Unlevered Beta for the firm, we take a weighted average of the Unlevered Betas, using the proportion of firm value derived from each business as the wieighting factor. These firm values will have to be estimated because divisions of a firm usually do not have market values available. 30 If these values cannot be estimated, we can use operating income or revenues as weights. This weighted average is called the bottom-up Unlevered Beta . In general, it is good practice to estimate two Unlevered Betas for a firm, one for just the operating assets of the firm, and one with cash and marketable securities treated as a separate business, with a beta of zero. 4. Calculate the current debt-to-equity ratio for the firm, using market values if available. Al-ternatively, use the target debt-to-equity ratio specified by the management of the firm or industry-typical debt ratios. If you can break the debt down by business, calculate the debt ratios for each business that the firm is in. 5. Estimate the levered beta for the equity in the firm (and each of its businesses) using the Unlevered Beta from Step 3 and the debt-to-equity ratio from Step 4. Clearly, this process rests on being able to identify the Unlevered Betas of individual businesses. There are three advantages associated with using bottom-up betas, and they are significant: • We can estimate betas for firms that have no price history because all we need is an identification of the business or businesses they operate in. In other words, we can estimate bottom-up betas for initial public offerings, private businesses, and divisions of companies. • Because the beta for the business is obtained by averaging across a large number of regression betas, it will be more precise than any individual firm’s regression beta estimate.

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  Valuation

  Mergers, Buyouts and Restructuring

  • Enrique R. Arzac(Author)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  Hence, it follows from Equation (3.8) that the beta of equity is β E = (1 + D/E)β U − (D/E)β D , (3.15) and β U = (1 + D/E) −1 [β E + (D/E)β D ] gives the unlevered or asset beta for given observed equity and debt betas. For riskless debt such that β D = 0, 38 β E = (1 + D/E)β U (3.16) which, in practice, is a suitable approximation to Equation (3.15) given the small beta of corporate bonds. Inverting Equation (3.16) yields β U = (1 + D/E) −1 β E (3.17) Equation (3.16) was derived without assuming a specific tax regime, which means that it is valid when the tax shield is not affected by personal taxes as well as when it is. 39 In conclusion, in the common case of firms following constant target net debt ratios such that discounting at WACC is warranted, the adjustment of comparable betas for differences in leverage has to be done using Equation (3.15) or (3.16) and not the commonly used Equation (3.14). The latter will overestimate the Unlevered Beta for any observed equity beta. Exhibit 3.5 computes the unlevered cost of capital for the companies of Exhibit 3.4. Note that net debt is defined as all interest-bearing debt minus cash and marketable securities. Hence, the resulting β coefficients correspond to the unlevered assets of the firm excluding cash and marketable securities, and Equation (3.17) applies even when net debt is negative. 40 *3.5 BEYOND THE CAPITAL ASSET PRICING MODEL 41 3.5.1 The Original CAPM So far, the estimation of the cost of equity has been based on the notion that investors demand compensation for bearing non-diversifiable risk and that such compensation can be measured by multiplying the market risk premium by a measure of the non-diversifiable risk of the stock. This intuitive notion received a theoretical foundation in the mid-1960s with the development of the capital asset pricing model (CAPM).

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