Levered Beta

Definition

Levered beta is a measure of the systematic risk of a company's stock that takes into account the impact of debt financing on the company's overall risk profile. It reflects the sensitivity of the company's stock returns to changes in the overall market returns, considering the company's capital structure.

5 Must Know Facts For Your Next Test

1. Levered beta is calculated by adjusting the company's unlevered beta to account for the impact of debt financing on the company's risk.
2. Increasing a company's financial leverage (debt-to-equity ratio) typically increases its levered beta, as debt amplifies the company's sensitivity to market movements.
3. Levered beta is an important input in the calculation of a company's weighted average cost of capital (WACC), which is used to discount the company's future cash flows in valuation analysis.
4. Levered beta is influenced by factors such as the company's debt-to-equity ratio, the tax rate, and the risk-free rate of return.
5. Comparing a company's levered beta to its unlevered beta can provide insights into the impact of its capital structure on its overall risk profile.

Review Questions

• Explain how a company's capital structure affects its levered beta.
  • A company's capital structure, specifically the ratio of debt to equity financing, has a significant impact on its levered beta. Increasing the proportion of debt in the capital structure amplifies the company's sensitivity to market movements, as debt financing adds financial leverage. This higher financial leverage results in a higher levered beta, reflecting the increased systematic risk of the company's stock returns. Conversely, a lower debt-to-equity ratio leads to a lower levered beta, indicating the company's stock is less sensitive to changes in the overall market.
• Describe the role of levered beta in the calculation of a company's weighted average cost of capital (WACC).
  • Levered beta is a crucial input in the calculation of a company's weighted average cost of capital (WACC). WACC represents the average cost of a company's different capital sources, weighted by their respective market value proportions. Levered beta is used to estimate the cost of equity, which is a key component of WACC. By incorporating the company's levered beta, the cost of equity calculation reflects the systematic risk of the company's stock returns, considering the impact of its capital structure. The calculated WACC is then used to discount the company's future cash flows in valuation analysis, making levered beta an essential factor in determining the company's intrinsic value.
• Analyze how changes in a company's debt-to-equity ratio would impact its levered beta and, consequently, its WACC and valuation.
  • $$\text{If a company increases its debt-to-equity ratio, its levered beta will typically increase.} \ \text{This higher levered beta will lead to a higher cost of equity, which is a component of the company's WACC.} \ \text{The increased WACC will result in a higher discount rate used to value the company's future cash flows.} \ \text{Consequently, the company's intrinsic value, as determined by the discounted cash flow analysis, will decrease.} \ \text{Conversely, if the company reduces its debt-to-equity ratio, its levered beta and WACC will decrease, leading to a higher valuation.} \ \text{Therefore, changes in a company's capital structure have a direct impact on its levered beta, WACC, and ultimately, its overall valuation.}$$

Related terms

Unlevered Beta: Unlevered beta is a measure of a company's systematic risk without considering the effects of debt financing. It represents the inherent risk of the company's underlying business operations.

Weighted Average Cost of Capital (WACC): WACC is the average cost of a company's different capital sources, weighted by their respective market value proportions. It is used to discount a company's future cash flows in valuation analysis.

Capital Structure: Capital structure refers to the mix of a company's long-term debt, preferred stock, and common equity financing. It determines the company's financial leverage and risk profile.