Christian Debt Recovery

Debt Equity Analysis

May 31st, 2008 |

Author: Gavin

debt equity analysis

DCF Analysis: Unlevering a Beta

In the process of calculating a weighted average cost of capital for a discounted cash flow analysis, one must often unlever a Beta. Let’s take a look at the process.

Calculating Beta is the fun part of the capital asset pricing model (CAPM). Since Beta is a measure of how a stock moves with the overall market, you would calculate it by doing a regression analysis of the stocks performance against a broad index such as the S&P 500. Fortunately, many stock information services such as Bloomberg or Yahoo Finance have already calculated this value for stocks.

The problem with these Betas is that they are levered. We need an unlevered value for our cost of equity calculation. The reason we need this unlevered value is that the amount of debt or leverage that a company has can affect its Beta. And since a potential acquirer of a company could choose to significantly alter its capital structure, we should take out the effect of leverage to have a better sense of the company’s value.

Unlevering a Beta

Unlevering a Beta can be a tricky process. The formula for an unlevered Beta is as follows:

Unlevered Beta = Equity Beta / [ 1 + (1 - tax rate) * Debt / Equity]

The equity Beta would be the Beta you get from Yahoo Finance on the Key Statistics page. You can calculate the company’s tax rate by dividing tax expenses by before tax income on the company’s income statement. Debt is the company’s total debt. Equity in this case is the market value of the company’s equity – its market capitalization.

Beta Comps

As if calculating an unlevered Beta were not tricky enough, you can’t calculate a Beta for private companies. Instead, we must analyze industry comparables to find an average or median unlevered Beta as an approximation for our company’s Beta.

What this means is that we need to look up public comps for our company, calculate each of their unlevered Betas and take an average. We can now use this average Beta in our capital asset pricing model and in calculating weighted-average cost of capital.

Want to look at a sample discounted cashflow model and take a more detailed look at a discounted cash flow analysis? Visit Finance Ocean. Or try taking a finance quiz!

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