Levered Beta

3 Key excerpts on "Levered Beta"

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  Corporate Value Creation

  An Operations Framework for Nonfinancial Managers

  • Lawrence C. Karlson(Author)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  13
• In practical terms, if a company has a Beta of 1.2, then the return on that company's security varies 1.2% for every 1% change in the index.
As a company takes on debt, it places obligations ahead of the equity holders. The interest and debt amortization have to be serviced from the company's cash flow. This results in an increase in the company's systematic risk and a corresponding increase in the company's Beta. A company with no debt has an unlevered equity Beta. Conversely, a company with debt has a levered equity Beta.
The relationship between the unlevered and Levered Betas is expressed by Equations [3-31] and [3-32]:14
[3-31]
[3-32]
where:
• Beta
  L
  = The levered equity Beta
• Beta
  U
  = The unlevered equity Beta
• TR = The marginal tax rate of the corporation
• B = Market value of the debt of the company under consideration
• E = Market value of the equity of the company under consideration
As can be seen from these equations, if the company doesn't have any debt, the value of B/E = 0, Beta
U
= Beta
L,
and there is no need to be concerned about which Beta one is talking about. However, in the real world, companies have debt and as the B/E ratio increases, the risk profile of the company changes and Beta increases as a result of the leverage.

Estimating Beta for Non-Public Companies or Business Units

As mentioned earlier, Beta for public companies is readily available from various sources. Obtaining a value for Beta can be problematic if the company in question is not publicly traded. Two of the most straightforward techniques that can be used to estimate a Beta for a division, business unit, or private company are “industry comparisons” and “comparable companies.” More sophisticated techniques such as “multiple regression” and “covariance of earnings” exist but are beyond the scope of this book.

Industry Comparisons

This technique is quite simple. A group of managers are asked to look at a list of industries and select the industry with the risk profile most like their own business or division. After an iterative process, the group usually agrees on the most appropriate industry. Using this technique, the Beta of the industry selected by the managers is the Levered Beta of their business or division. (The industry Beta will almost always be levered because it is composed of a wide cross-section of companies, many of which will have debt.) Once the Levered Beta has been established the next step is to decide on what the tax rate and ratio of debt to equity this industry Beta represents. This can be done by taking an average of the industry companies that you think are most representative of the business or division in question and then using Equation [3-32] to calculate the unLevered Beta of the representative companies. This is the unLevered Beta for the company or division in question. If the company or division under consideration has debt, then the Levered Beta is obtained by substituting the relevant Debt-to-Equity ratio and Tax Rate into Equation [3-31].