How do you get to Beta in the Cost of Equity calculation?

How do you get to Beta in the Cost of Equity calculation?

• A. You look up the Beta for each Comparable Company, un-lever each one, take the median, and then lever it based on your company's capital structure
• B. You use the company's current levered beta without adjustments
• C. You use the Beta of the market index regardless of debt
• D. You ignore Beta and use industry beta instead

Answer: (A)

This question tests how to estimate a company’s beta for CAPM by separating business risk from financial risk and then reapplying your own leverage. The idea is to start with comparable firms’ betas, strip out the effects of their debt to measure pure business risk (unlevered beta), summarize those unlevered betas with a robust statistic like the median to avoid outliers, and then re-apply your own capital structure to reflect your firm’s financial risk. Concretely, you take each comparable’s levered beta and remove the impact of debt to get the unlevered beta. A common formula is Unlevered Beta = Levered Beta / [1 + (1 − tax rate) × Debt/Equity]. After obtaining these unlevered betas, you take the median to form a representative business-risk beta. Then you re-lever to match your company’s target leverage: Re-levered Beta = Unlevered Beta × [1 + (1 − tax rate) × Debt/Equity_target]. This gives a beta that reflects both the underlying business risk and your expected capital structure, which you can use in the CAPM to estimate the cost of equity. Using the current levered beta directly would mix in your current debt level and won’t isolate business risk. Relying on the market beta (which equals 1) ignores company-specific risk. Using industry beta ignores differences between firms in the same industry.

This question tests how to estimate a company’s beta for CAPM by separating business risk from financial risk and then reapplying your own leverage. The idea is to start with comparable firms’ betas, strip out the effects of their debt to measure pure business risk (unlevered beta), summarize those unlevered betas with a robust statistic like the median to avoid outliers, and then re-apply your own capital structure to reflect your firm’s financial risk.

Concretely, you take each comparable’s levered beta and remove the impact of debt to get the unlevered beta. A common formula is Unlevered Beta = Levered Beta / [1 + (1 − tax rate) × Debt/Equity]. After obtaining these unlevered betas, you take the median to form a representative business-risk beta. Then you re-lever to match your company’s target leverage: Re-levered Beta = Unlevered Beta × [1 + (1 − tax rate) × Debt/Equity_target]. This gives a beta that reflects both the underlying business risk and your expected capital structure, which you can use in the CAPM to estimate the cost of equity.

Using the current levered beta directly would mix in your current debt level and won’t isolate business risk. Relying on the market beta (which equals 1) ignores company-specific risk. Using industry beta ignores differences between firms in the same industry.