Levered Beta - Explained
What is a Levered Beta?
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Table of ContentsWhat is a Levered Beta?How is a Levered Beta Used?Example of How to Calculate Levered Beta
What is a Levered Beta?
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.
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How is a Levered Beta Used?
The Levered Beta of a stock is read in relation to the volatility of the stock market. A stocks 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 stocks 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.