Definition
The Levered Beta Formula, also known as equity beta or leveraged beta, is used to calculate the risk factor of a leveraged company (a company with debt), accounting for its financial leverage. It is a measure of the systematic risk of a stock compared to the market as a whole, while considering the impact of the firm’s financial structure. The formula is Levered Beta = Unlevered Beta * (1+ ((1- tax rate) * (total debt/ equity))).
Key Takeaways
- The Levered Beta Formula is essentially used to calculate the risk of an equity or stock of a company which has debt. It is an indicator of the investment’s risk associated with market movements.
- This formula considers debt in a company’s capital structure and hence provides a risk ratio for leveraged firms. A high levered Beta indicates a high risk or volatility, whereas a low levered Beta indicates less risk.
- Levered Beta is an important dimension in the Capital Asset Pricing Model (CAPM), which is used to calculate the required return for an investment. It provides a more suitable beta value for investors if the company’s debt-equity structure coincides with theirs.
Importance
The Levered Beta formula is a critical aspect of finance because it helps in evaluating and quantifying the risk or volatility of a company’s stock, relative to the overall market, specifically when the firm is leveraging financial sources like debt.
This formula considers the impact of a company’s debt on its stock volatility, making it a more precise measure of risk than Unlevered Beta.
By using the Levered Beta formula, investors, potential shareholders, and financial analysts have a more comprehensive understanding of the company’s financial risk profile, including the extent to which debt influences the volatility of the firm’s stock.
Therefore, it plays a significant role in investment decision-making and risk management.
Explanation
The Levered Beta Formula is a crucial tool in the field of finance that aids analysts and investors in assessing the risk associated with a particular investment in relation to the risk found in the broader market.
Specifically, it is used to measure the financial risk or volatility a firm’s equity faces due to the use of debt (leverage). The Levered Beta, often referred to as Equity Beta or just Beta, is an amplified depiction of the investment’s market risk, factoring in the impact of debt.
The purpose of the Levered Beta Formula is typically to provide more detailed insight into the true risk associated with a prospective investment.
Generally, firms with higher debt loads are more susceptible to economic downturns and setbacks due to increased financial obligations, thus amplifying both the risks and potential returns.
As a result, the Levered Beta Formula assists investors perfectly by enabling them to anticipate potential future volatility and make more informed decisions based on their risk tolerance and investment strategy.
Examples of Levered Beta Formula
TheTech Corporation: Let’s take the case of TheTech Corporation, a tech company with a beta of2 initially which reflects the company’s risk in comparison to the market. The company has a debt-to-equity ratio of5, tax rate 30%. Using the levered beta formula, we can adjust the beta to
44, which considers the additional risk of debt. The increased beta may alert investors to the increased level of risk involved in investing in TheTech Corporation after it took on more debt.BlueChip Company: The BlueChip Company is a mature company operating in a stable industry and has a beta of75, showing its lower volatility than the overall market. The company doesn’t carry any debt, giving them a debt-to-equity ratio of
However, if it decided to finance an expansion through leveraged debt, its levered beta would increase depending on the amount of debt they take on and their corporate tax rate. This signifies that taking on debt has increased the potential market risk of investing in BlueChip Company.VTech Toys: Let’s assume VTech Toys, a toy manufacturer has a levered beta of5, and it decides to pay off its high debt to lower the risk associated with its business thus decreasing its debt-to-equity ratio. After paying off debt, their new unlevered beta might be
This would indicate to investors that they have effectively reduced the risk associated with their stock by leveraging less debt.
Levered Beta Formula FAQ
What is the Levered Beta Formula?
The Levered Beta, also known as the Equity Beta or the Financial Risk, calculates the financial risk of a firm that is associated with the firm’s leverage or its financials. The general formula for Levered Beta is Levered Beta = Unlevered Beta * (1 + (1 – Tax Rate) * (Total Debt/Equity)).
How is the Levered Beta Formula Used?
The Levered Beta Formula is frequently used in the Capital Asset Pricing Model (CAPM) to estimate the cost of equity. It is also used to determine the financial risk related to a company’s debt, i.e., the risk of financial leverage that a business has taken on.
What is the Difference Between Levered and Unlevered Beta?
Levered Beta includes the financial risk of debt that a company might possess, while the Unlevered Beta, also known as the Asset Beta, accounts only for the business risk and does not consider the affect of debt. Therefore, Levered Beta will always be greater than or equal to Unlevered Beta assuming the firm has debt.
How Does Tax Rate Affect the Levered Beta?
The tax rate appears in the Levered Beta formula because interest expense on debt is tax-deductible. When a company has a high tax rate, the deductible component of debt increases which in turn lowers the cost of debt, reducing the firm’s levered Beta.
How Do You Apply the Levered Beta Formula in Real World Scenarios?
In a real-world scenario, to apply the levered Beta, you would first need to know the values of the company’s unlevered Beta, tax rate, total debt, and equity. Once these values are known, you can use the formula to calculate the levered Beta thus determining the level of financial risk of a company due to its debt.
Related Entrepreneurship Terms
- Cost of Equity
- Unlevered Beta
- Corporate Tax Rate
- Financial Leverage
- Equity Beta
Sources for More Information
- Investopedia: A comprehensive online resource for investment and financing information.
- Corporate Finance Institute: Provides a variety of educational resources on corporate finance, including Beta and Levered Beta.
- Wall Street Mojo: Offers detailed financial tutorials, including on Beta and Levered Beta.
- Fidelity: A widely respected and reputable source of investment and financial information.
