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 - ePub

  Strategic Corporate Finance

  Applications in Valuation and Capital Structure

  • Justin Pettit(Author)
  • 2011(Publication Date)
  • Wiley

    (Publisher)

  A simple mean or median of pure-play comparable Unlevered Betas (i.e., asset betas) may serve as a representative proxy for the company Unlevered Beta. The Unlevered Beta is then relevered based on a target capital structure. Asset beta, or Unlevered Beta, is adjusted to exclude financial risk from the market beta:

  Unlevered Beta = D/EV∗debt beta(1 − tax rate) + (1 − D/EV)∗levered beta

  D is debt, EV is enterprise value, and debt beta is estimated from credit spreads or direct regression of market data. The beta for a conglomerate can be a weighted average of division betas, based on each division’s contribution to the firm’s intrinsic value (capitalized operating cash flow may serve as a proxy).

  Portfolio Beta

  Where leverage ratios are similar across an entire industry, a portfolio beta may serve as a proxy for a company beta. The portfolio beta is derived from a single regression of cross-sectional returns for all company market return points. Include as much data as possible to minimize bias from any point. Avoid grouping, aggregating, or averaging your data.

  Secondary Regression by Segment

  In cases of highly vertically integrated industries (financial services and resource industries), where there are often only a few pure-play peer companies, a secondary regression by segment can be employed to determine a pure-play beta. This is especially helpful for estimating segment, or line-of-business, costs of capital within integrated industries. The dependent variable is each company’s Unlevered Beta, and the independent variables are the percentage exposures to different business segment (e.g., by revenue, assets, or operating income).

  For example, Table 1.2

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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].