Take the 2-minute tour ×
Quantitative Finance Stack Exchange is a question and answer site for finance professionals and academics. It's 100% free, no registration required.

I have derived a firm's cost of equity using the WACC formula (see here), which means that the cost of equity has factored in the firms' debt (i.e. levered beta) and now I need to calculate the firm's unlevered beta. Here is my solution thus far, please let me know if I am on the right track.

Formula to calculate unlevered beta:

βL = βU + [1 + (1 - t)(d/e)]

Where:
βL = the firm's beta with leverage = 1.5
βU = the firm's beta with no leverage
t = the corporate tax rate = 40%
d/e = the firms debt/equity ratio = 35/65

Calculations

1.1 = βU + [1 + (1 - 0.40)(35/65)]
1.1 = βU + [1 + (0.6)(0.538461538461538)]
1.1 = βU + [1 + (0.6)(0.538461538461538)]
1.1 = βU + 1.323077
βU = 1.323077 - 1.1
βU = 0.223077

UPDATE

I had some errors above, which were pointed out in the answer below. Here is the updated question (which I think is now correct).

Revised Formula to calculate unlevered beta:

βU = βL * [1 / (1 + (1 - t)(d/e))]

Where:
βL = the firm's beta with leverage = 1.5
βU = the firm's beta with no leverage
t = the corporate tax rate = 40%
d/e = the firms debt/equity ratio = 35/65

Revised Calculations

βU = 1.5 * [1 / (1 + (1 - 0.40)(35/65)) ]
βU = 1.5 * [1 / 1.323077]
βU = 1.5 * 0.755814
βU = 1.133721
share|improve this question
1  
Pages 53 and 54 of Volume 4 of the CFA level curriculum. I'm not sure where you're getting your formula but my book states $\beta_{\textrm{asset}} = \beta_{\textrm{equity}} \frac{1}{1+(1-t){\frac{D}{E}}}$. –  Bob Jansen Apr 29 '13 at 20:42
    
@BobJansen yes thank you, Bob. I had the formula wrong to begin with. –  Ben Apr 29 '13 at 21:11
    
If and only if the Beta of debt is zero. –  André Terra Jun 1 at 3:09

3 Answers 3

Your formula is adding where you should be multiplying, and you plugged your inputs into the wrong places (your levered Beta notably). In any case, the process for un-levering/re-levering the beta goes like so:

Step 1: Find benchmark company/asset/project Beta.

Step 2: Un-lever the benchmark Beta: Unlevered Beta = Levered Beta * (1 / ( 1 + (1 - t)*D/E))

Step 3: Re-lever the beta with your company/projects D/E Ratio: Un-levered Beta * (1 + (1-t)*D/E)

share|improve this answer
    
thank you! this is great. Will make amendments to original question to incorporate your answers... cheers –  Ben Apr 29 '13 at 21:02

Unlevered Beta (Beta asset) = Levered Beta / 1+(1-tax) Debt/Equity

Similarly , Levered Beta (Beta equity) = Unlevered Beta * 1+ (1-tax) Debt /Equity

share|improve this answer
    
These formulas assume debt carries a market risk of zero, which is a very simplifying (but sometimes inevitable) assumption. –  André Terra May 31 at 19:09

It depends. If, and only if, you assume that debt carries a market risk of exactly 0, you may use Hamada's equation to easily go from levered to unlevered beta.

Let $\theta = D/E$

  • $\beta^L = \beta^U *(1+(1-\tau) \theta)$
  • $\beta^U = \beta^L \div(1+(1-\tau)\theta)$

Where $\tau$ is the tax rate, and $D$ and $E$ are the firm's market value of debt and equity.

In practice, a lot of people use that just because it is hard to estimate debt betas.

If you dislike that simplifying assumption, and if you have a way to estimate a debt beta, then the correct equation is:

  • $\beta^L = \beta^U *(1+(1-\tau)\theta) \space – \space \beta_d(1-\tau)\theta$
share|improve this answer
    
For a quick source to this information, please see page 9 (printed page 71) of Prof. Aswath Damodaran's class slides at people.stern.nyu.edu/adamodar/pdfiles/eqnotes/discrate2.pdf –  André Terra May 31 at 19:08

Your Answer

 
discard

By posting your answer, you agree to the privacy policy and terms of service.

Not the answer you're looking for? Browse other questions tagged or ask your own question.