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Levered Beta (CAPM) Definition
In a Capital Asset Pricing Model (CAPM), the risk of holding a stock, calculated as a function of its financial debt vs. equity, is called Levered Beta or Equity Beta.
The amount of debt a firm owes in relation to its equity holdings makes up the key factor in measuring its Levered Beta for investors buying its stocks.
A company with increasing debt while the equity value stays constant carries a higher risk value.
A Little More on What is Levered Beta
The Levered Beta of a stock is read in relation to the volatility of the stock market.
A stock’s performance is influenced by several macroeconomic and microeconomic factors – like paucity of resources, political upheavals, natural calamities, etc. These are unmitigated risks that investors and firms have little to no control over.
Removing the debt component from the risk factor calculation gives the value of Unlevered Beta.
Levered Beta is then calculated as a function of Unlevered Beta and a stock’s debt to equity ratio.
Levered Beta with a value of 1 has the same volatility as the stock market, hence it is considered a medium risk stock.
A Beta value greater than 1 implies a high-risk stock compared to market volatility.
Conversely, a Beta value of less than 1 implies a relatively safe stock in that it is less affected by market risks.
Example of How to Calculate Levered Beta
Suppose the Levered Beta of a stock is 1.20, while the ratio of its debt-to-equity is 8%, and the company is taxed at 20%.
The formula to calculate the value of Unlevered Beta is:
Beta / 1 + (1 – tax rate) x (Debt/Equity) = 1.20 / 1 + (1 – 20%) x 8% = 1.26.
The formula to calculate the Levered Beta is:
Unlevered beta (1+ (1-tax rate) (Debt/Equity)) = 1.26 x (1 + (1-20%) x 8%) = 1.34
These formulae can be used to plot the different risk factors associated with varying amounts of debts and equity values.
Academic Research on Levered Beta
Levered and unlevered beta, Fernandez, P. (2006). Levered and unlevered beta. This article explores the relationship between Levered and Unlevered Beta.
The suitability of proxy levered beta in business valuation: Evidence from vietnam, Nguyen, K. D., Sinh, H. A. Y., Ngoc-Thuy-Duong, U. Y. N. H., & Cong-Nguyen-Bao, T. O. (2018). The suitability of proxy levered beta in business valuation: Evidence from vietnam. Asian Economic and Financial Review, 8(2), 248-268. The study tests corporate valuation in light of Proxy Levered Beta (PLB) in Vietnam.
THE SUITABILITY OF PROXY LEVERED BETA IN BUSINESS VALUATION: EVIDENCE FROM VIETNAM, Sinh, H. A. Y. (2018). THE SUITABILITY OF PROXY LEVERED BETA IN BUSINESS VALUATION: EVIDENCE FROM VIETNAM.
Debt capacity and the capital budgeting decision: a comment, Conine, T. E. (1980). Debt capacity and the capital budgeting decision: a comment. Financial Management, 9(1), 20-22. This journal defines a project’s debt carrying capacity and studies it in detail.
ASCERTAINING THE DIVISONAL BETA FOR PROJECT EVALUATION-THE PURE PLAY METHOD-A DISCUSSION, Parasuraman, N. R. (2002). ASCERTAINING THE DIVISONAL BETA FOR PROJECT EVALUATION-THE PURE PLAY METHOD-A DISCUSSION. CHARTERED ACCOUNTANT-NEW DELHI-, 51(5), 546-549. This paper discusses the difficulty of obtaining Beta values for individual projects and demonstrates the efficacy of the Pure Play Method in overcoming this difficulty.
Reformulating tax shield valuation: A note, Miles, J. A., & Ezzell, J. R. (1985). Reformulating tax shield valuation: A note. The Journal of Finance, 40(5), 1485-1492. This paper takes a look at corporate debt and financing and how it effects Beta scores and equity valuation.
Betting against beta, Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial Economics, 111(1), 1-25. This journal studies empirical data across 20 international stock exchanges and presents a model with margin and leverage limitations across time and investors. The analyses and predictions are discussed in detail.
Correcting betas for changes in firm and market leverage, Lally, M. (1998). Correcting betas for changes in firm and market leverage. This paper presents an alternative way of calculating betas free of market biases.
FEVA: A financial and economic approach to valuation, Adsera, X., & Vinolas, P. (2003). FEVA: A financial and economic approach to valuation. Financial Analysts Journal, 59(2), 80-87. This paper provides an alternative corporate value calculation method that gives consistent results unlike the current system that gives different outputs for the same input values.
The beta dilemma in emerging markets, Pereiro, L. E. (2010). The beta dilemma in emerging markets. Journal of Applied Corporate Finance, 22(4), 110-122. This journal discusses the difficulty of assessing equity costs in emerging markets resulting in a ‘beta dilemma’ that skews calculations. A solution is also proposed to counter this equivalence problem.
Adapting the APV valuation methodology and the beta gearing formula to the dividend imputation tax system, Monkhouse, P. H. (1997). Adapting the APV valuation methodology and the beta gearing formula to the dividend imputation tax system. Accounting & Finance, 37(1), 69-88. This paper takes a quantitative approach to adapting the APV valuation methodology to the Australian dividend imputation tax system. It also studies the resulting impact on betas due to the change in assumed value of credits.