Unlevered Beta

Note: This influences the Cost of equity (C of E), which in turn, effects the
WACC

C of E = Risk free rate (Rf) + B (Rm – Rf), where (Rm – Rf) is called as Market risk
premium [Cost of Equity is also called as Cost of Capital]
WACC = proportion of cost of post-tax debt (plus) proportion of cost of equity (or
capital) → On the basis of debt – equity ratio

What is 'Unlevered Beta'

Unlevered beta compares the risk of an unlevered company to the risk of the market.
The unlevered beta is the beta of a company without taking its debt into account.
Unlevering a beta removes the financial effects of leverage. This number provides a
measure of how much systematic risk a firm's equity has when compared to the
market.

Unlevered beta is also called asset beta.

BREAKING DOWN 'Unlevered Beta'

Unlevering the beta removes any beneficial effects gained by adding debt to the
firm's capital structure. Comparing companies' unlevered betas gives an investor a better
idea of how much risk he is taking on when he purchases the stock.

In finance, beta is a measure of risk. Specifically, it is the slope of the coefficient for a stock
regressed against a market index like the Standard & Poor's (S&P) 500 Index. Unlevered
beta removes the impact of debt or leverage on the regression.

Systematic Risk and Beta

Systematic risk is the type of risk that is caused by factors beyond a company's control. This
type of risk cannot be diversified away. Examples of systematic risk include natural
disasters, political events, inflation, and wars. To measure the level of systematic risk
or volatility of a stock or portfolio, the beta is used.

Beta is a statistical measure that compares the volatility of the price of a stock against the
volatility of the broader market. If the volatility of the stock, as measured by beta, is higher,
the stock is considered risky. If the volatility of the stock is lower, the stock is said to have
less risk.
A beta of 1 is equivalent to the risk of the broader market. That is, a company with a beta of
1 has the same systematic risk as the broader market. A beta of 2 means the company is
twice as volatile as the overall market, but a beta of less than 1 means the company is less
volatile and presents less risk than the broader market.

Unlevered Beta
A key determinant of beta is leverage, which measures the level of a company’s debt to its
equity. Levered beta measures the risk of a firm with debt and equity in its capital
structure to the volatility of the market. The other type of beta is known as unlevered beta.

Unlevered beta measures the risk of an investment by comparing the market to a company
with no debt. Unlevered means no leverage. Leverage means debt. Therefore, unlevered
means no debt.

The level of debt that a company has can affect its performance, making it more sensitive
to changes in its stock price. Note that the company being analyzed has debt in its financial
statements, but unlevered beta treats it like it has no debt by stripping any debt off the
calculation. The more debt or leverage a company has, the more earnings are used to
paying back that debt. This increases the risk associated with the stock. Since companies
have different capital structures and levels of debt, to effectively compare them against
each other or against the market, an analyst can treat them as unleveraged by using the
unlevered beta which does not take into account the company’s financial leverage and the
impact of its debt on its performance. This way, only the sensitivity of a firm’s equity to the
market will be factored.

To unlever the beta, the levered beta for the company has to be known in addition to the
company’s debt-equity ratio and corporate tax rate.

BU = BL / [1 + ((1 - Tax Rate) x Debt/Equity)]

Let’s calculate the unlevered beta for Tesla, Inc. As of November 2017, its beta is 0.73, D/E
ratio is 2.2, and its corporate tax rate is 35%.

Tesla BU = 0.73 / [1 +((1 – 0.35) x 2.2)] = 0.73 / 1 + (0.65 x 2.2) = 0.73 / 2.43 = 0.30

Unlevered beta will always be lower than levered beta. If the unlevered beta is positive,
investors will invest in the company's stock when prices are expected to rise. A negative
unlevered beta will prompt investors to invest in the stock when prices are expected to
decline.

Dr. Vijay Bhasker V.