Levered Beta (Definition, Formula)| How to Calculate Levered Beta?

What is Levered Beta?

Levered beta is a measure of the systematic riskSystematic Risk Systematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more of a stock that includes risk due to macroeconomic events like war, political events, recession, etc. Systematic risk is the risk that is inherent to the entire market and is also known as the undiversifiable risk. It cannot be reduced through diversification. The levered beta formula is used in the CAPMCAPM The Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more.

The levered beta formula is represented as follows,

Levered Beta = Unlevered Beta (1 + (1-t)(Debt/Equity))

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For eg:
Source: Levered Beta (wallstreetmojo.com)

Where t is the tax rate

Alternatively, the formula is:

Unlevered Beta = Levered Beta (1 + (1-t)(Debt/Equity))

Where t is the tax rate

Explanation of Levered Beta Formula

In order to calculate the levered beta, use the following steps:

Step 1: Find out the Unlevered Beta

Step 2: Find out the tax rate for the stock. The tax rate is represented by t.

Step 3: Find out the total debt and equity valueEquity Value Equity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.read more.

The formula for calculating total debt is:

Debt = Short term debt + Long term debt

Step 4: Calculation using the formula:

Levered Beta = Unlevered Beta (1 + (1-t)(Debt/Equity))

In order to calculate the unlevered beta, we just adjust the above formula. The steps for calculation of the unlevered beta are as under:

Step 1: Calculate the levered beta.

Step 2: Find out the tax rate for the organization. The tax rate is represented by t.

Step 3: Find out the total debt and equity value.

Step 4: Calculation of the unlevered beta using the formula:

Unlevered Beta =Levered Beta (1 + (1-t)(Debt/Equity))

Examples of Levered Beta Formula

Let’s see some simple to advanced practical examples to understand it better.

You can download this Levered Beta Formula Excel Template here – Levered Beta Formula Excel Template

Example #1

Calculate the levered beta for Company A using the following information:

Unlevred Beta: 0.8
Tax Rate: 25 %
Debt Equity Ratio: 0.30

Solution

Calculation

=0.8*(1+(1-25%)*0.30

= 0.98

Example #2

The CFO of a Fabrix Inc. got some information from the financial statements of the company and a popular financial database. The information is as under:

Short Term Debt: 5000
Long Term Debt: 4000
Equity: 18000
Tax Rate: 0.35
Beta: 1.3

Calculate the Unlevered beta from the above information.

Solution

Calculation of Debt

= 5000 + 4000
= 9000

Calculation of Debt Equity RatioDebt Equity Ratio The debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more

=9000/18000
= 0.5

Calculation of Unlevered Beta

= 1.3/1+(1-0.35)*0.5

= 0.98

Example #3

Plumber Inc. is a manufacturing concern listed on the stock exchangesThe Stock Exchanges Stock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more. The Chief Financial Officer (CFO) of Prumber Inc. wanted to calculate the riskiness of a stock. For this purpose, he wants to calculate the levered beta. He gives you the following information, which he has obtained from the financial statements of the company and a popular financial database that gives relevant financial information related to the company. Let us calculate the levered beta from the information given below.

Unlevered Beta: 0.85
Tax Rate: 30%
Equity: $80,000
Non-Current Term Debt: $50,000
Current Term Debt: $30,000

Calculate the levered beta from the above information.

Solution

Calculation of Total Debt

= $50,000 + $30,000
= 80,000

Calculation of Debt Equity Ratio

=80,000/80,000
= 1

= 0.85* (1+ (1-0.30)*1)

= 1.445

Relevance and Uses

The risk of a firm in its capital structure to the volatility in the market is measured by levered beta. It measures the risk of a company that cannot be reduced by diversification. Levered beta considers both equity and debt while calculating the risk of a company. A beta of 1 indicates that the riskiness of the stock is similar to that of the market.

A beta of greater than 1 indicates that the stock is riskier than the market. A beta of less than 1 indicates that the stock is less risky as compared to the market. For instance, a beta in financeBeta In Finance Beta is a financial metric that determines how sensitive a stock's price is to changes in the market price (index). It's used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns.read more indicates that the stock has double the volatility as compared to the market. A negative beta implies that the stock has an inverse correlationAn Inverse Correlation Inverse correlation denotes an adverse relationship between two variables. Thus, the increase in the value of one variable results in the decrease of the other variable's value.read more with the market.

Different types of firms have different betas based on their characteristics. Certain cyclical sectors such as stock brokerage firms, automobiles, banking are known to have higher betas as compared to non-cyclical sectors. Similarly, sectors like fast-moving consumer goods (FMCG), pharma, etc. have lesser betas as compared to cyclical sectors. Firms with higher operating leverageOperating Leverage Operating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.read more tend to have higher betas as their profits are more volatile as compared to their peers. Similarly, firms with higher financial leverage have higher betas as compared to those with lesser financial leverage. In other words, firms with higher levels of debt have higher betas. It is because fixed interest expenses have to be paid on this debt irrespective of the levels of profitabilityProfitability Profitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more.

On the other hand, the unlevered beta measures the market risk of a companyMarket Risk Of A Company Market risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more without the impact of debt. Thus, the contribution of equity of a company to its risk is measured by unlevered beta.

One of the criticisms of beta is that a single number that is dependent on past price fluctuations cannot represent the risk entailed by security. Similarly, beta does not consider fundamental factors related to the company. The underlying assumption in beta is that the downside riskDownside Risk Downside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. read more and upside potential are equal, which sounds intuitively incorrect. Similarly, the past performance of a security may not predict the future risk of security.