The unlevered beta is a measure of the company’s risk after removing the effect of the company’s debt. The unlevered beta is a measure of the company’s risk after removing the effect of the company’s debt. This beta represents what the company would have if it had no debt and relied solely on financing through equity.
What is beta?
To understand unlevered beta, you first need to grasp the basics of beta in general. Note: beta is a measure of investment risk in terms of its volatility relative to the market. In other words, it measures the investment’s exposure to systematic risk. To calculate beta, you start by dividing the standard deviation of the investment return by the standard deviation of the market return. Then multiply your answer by the correlation coefficient between the stock return and the market return. Beta can also be calculated using regression analysis. The value of beta tells you the relationship between investment returns and market returns. When beta equals one, it is expected that the asset will move exactly with the market. When beta is greater than one, the security is expected to be more volatile than the overall market. When beta is less than one, the security is expected to be less volatile than the market. Often, the S&P 500 index is used to represent the market when calculating beta. Higher beta stocks are expected to provide higher returns during periods when the market as a whole rises. Higher beta stocks are also expected to produce worse returns than the market when the overall market declines. Beta is one of the key values in the Capital Asset Pricing Model (CAPM), which is commonly used to assess risk and determine the cost of capital for a company’s equity.
How does unlevered beta work?
In most cases, when you see beta being used or read about it in a book or magazine, the standard beta is being used. This version of beta can be considered “leveraged” because it includes the impact of the company’s use of debt or leverage. Note: By including debt, beta measures the effects of both business risk and financial risk of the company at its current debt level. Unlevered beta, by removing the effect of the company’s current debt level, measures only the company’s fundamental risk, regardless of financing. A company may have different capital structures, each affecting beta in different ways, and assessing the impact of the company’s business risk without including debt can be useful. The institution may also want to know what its cost of equity would be at different levels of debt. Unlevered beta can be useful in these cases.
How to calculate unlevered beta
To calculate unlevered beta, you first need to compute the standard or regular beta, as explained above. You can then adjust this value to find the unlevered beta. The formula for unlevered beta is: unlevered beta = beta / (1 + (1 – tax rate) (debt / equity)). The last part of the formula is the debt-to-equity ratio, which shows how the standard beta is adjusted based on the amount of debt the company has. As an example of unlevered beta, let’s assume you have a company with a beta of 1.7 and a debt-to-equity ratio of 0.4. You can use a corporate tax rate of 21%. The unlevered beta for this company would be: 1.7 / (1 + (1 – 0.21) (0.4)) = 1.29. As you can see, removing the effect of the company’s debt lowered beta. This is logical and makes sense theoretically because debt is a source of risk. Since beta measures risk, removing debt should lower beta.
Taking
The Lesson
Beta is a measure of a company’s risk relative to the market. It is also a key component of the Capital Asset Pricing Model, which is often used to estimate the cost of equity financing for commercial companies. Beta encompasses the effects of both business risk and financial risk of the company. Unlevered beta does not include the company’s debt. Beta is typically calculated by including the impact of the company’s debt. Unlevered beta can be obtained by adjusting the company’s regular beta.
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Sources: The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
Herbert P. Mayo. “Investments: An Introduction.” Page 163. Cengage Learning, 2020. Accessed October 20, 2021.
Brigham and Ehrhardt. “Financial Management: Theory and Practice.” Page 624. Cengage Learning, 2020. Accessed October 20, 2021.
Source: https://www.thebalancemoney.com/what-is-unlevered-beta-5206570
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