Financial Modeling Self Study Program

When using the CAPM for purposes of calculating WACC, why do you have to unlever and then relever Beta?

In order to use the CAPM to calculate our cost of equity, we need to estimate the appropriate Beta.  We typically get the appropriate Beta from our comparable companies (often the mean or median Beta).  However before we can use this “industry” Beta we must first unlever the Beta of each of our comps.  The Beta that we will get (say from Bloomberg or Barra) will be a levered Beta.

Recall what Beta is:  in simple terms, how risky a stock is relative to the market.  Other things being equal, stocks of companies that have debt are somewhat more risky that stocks of companies without debt (or that have less debt).  This is because even a small amount of debt increases the risk of bankruptcy and also because any obligation to pay interest represents funds that cannot be used for running and growing the business.  In other words, debt reduces the flexibility of management which makes owning equity in the company more risky.

Now, in order to use the Betas of the comps to conclude an appropriate Beta for the company we are valuing, we must first strip out the impact of debt from the comps’ Betas.  This is known as unlevering Beta.  After unlevering the Betas, we can now use the appropriate “industry” Beta (e.g. the mean of the comps’ unlevered Betas) and relever it for the appropriate capital structure of the company being valued.  After relevering, we can use the levered Beta in the CAPM formula to calculate cost of equity.

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