Cost of capital
Unlevering and relevering beta
Estimate a project's beta from comparable companies by stripping out their leverage and adding back the project's own.
Learning objectives
- Explain why observed equity betas mix business risk and financial risk
- Unlever peer betas to asset betas and relever at a target capital structure
- Turn a relevered beta into a cost of equity and a project WACC
A project in a new line of business shouldn't be discounted at the company's own cost of capital: its risk is the risk of the new business. The usual approach is to borrow betas from listed companies that already operate in that business.
But each peer's equity beta reflects two things: the risk of its business (asset beta) and the extra risk its shareholders bear because of its borrowing (financial risk). A heavily indebted peer has a higher equity beta than an identical business with no debt. So you first unlever each peer's beta to remove its leverage, average the asset betas, then relever at the capital structure the project will use.
βU = βL ÷ [1 + (1 − t) × D/E] βL = βU × [1 + (1 − t) × D/E]
- βL
- levered (equity) beta, observed in share prices
- βU
- unlevered (asset) beta: the business risk alone
- D/E
- debt-to-equity, at market values
- t
- tax rate
Included with a Formula Quest membership
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