What is Levered Beta?
Levered Beta, also known as equity beta, measures the systematic risk of a company's equity, taking into account the impact of debt financing. It reflects the volatility of a company's stock relative to the overall market
Where:
βₑ: Levered Betaβᵤ: Unlevered Beta (systematic risk of the company’s assets without leverage)t: Corporate tax rateD/E: Debt-to-equity ratio (leverage)
How is Levered Beta Used in WACC?
Levered Beta is a critical input in calculating the Cost of Equity using the Capital Asset Pricing Model (CAPM):
Where:
rₓ: Risk-free rateβₑ: Levered BetaMRP: Market Risk Premium
Cost of Equity and WACC:
Levered Beta reflects the risk investors associate with the company's equity, given its debt levels.
The higher the Levered Beta, the higher the Cost of Equity, which increases the WACC:
Relevering Beta for Peer Comparisons:
Companies often use comparable firms’ betas to estimate their Levered Beta.
By unlevering the beta of a peer group and then relevering it with the company’s own target capital structure, you can tailor the beta to reflect the company’s specific risk profile.
Why is Levered Beta Important in WACC?
Captures Financial Risk:
Leverage (debt) increases financial risk by amplifying earnings volatility. Since interest payments are fixed, companies with higher leverage experience greater swings in net income, which increases their sensitivity to market movements. Levered Beta accounts for this additional volatility.
Tailors Cost of Equity:
Levered Beta adjusts the Cost of Equity by incorporating both the company’s inherent business risk (Unlevered Beta) and the added financial risk from leverage. This ensures that investors' required return accurately reflects both components.
Industry and Capital Structure Sensitivity:
Industries have different betas due to varying levels of systematic risk. However, even within the same industry, a company's capital structure influences its risk profile—companies with more debt have higher Levered Betas than those with less leverage.
Direct Impact on WACC:
A higher Levered Beta increases the Cost of Equity, which raises the WACC. Since WACC serves as the discount rate for valuation and investment analysis, a higher WACC reduces the number of projects that can generate returns above the required threshold, potentially limiting investment opportunities