What is the purpose of un-levering and re-levering Beta in the Cost of Equity calculation?

What is the purpose of un-levering and re-levering Beta in the Cost of Equity calculation?

• A. To neutralize capital structure differences when comparing betas
• B. To adjust for tax rate in WACC
• C. To estimate cost of debt
• D. To determine terminal value growth rate

Answer: (A)

Beta reflects both business risk and the risk from financial leverage. Un-levering removes the debt-driven financial risk, leaving an asset beta that represents the underlying operating risk of the business. This makes it possible to compare how risky the actual business is across firms with different levels of debt. Re-levering then applies the target capital structure to that asset beta, producing a levered beta that matches the firm’s intended mix of debt and equity. This levered beta is what you use in the CAPM to estimate the cost of equity. In short, un-levering isolates business risk for comparison, and re-levering adjusts that risk to the company’s own financing, which is why this process is used.

Beta reflects both business risk and the risk from financial leverage. Un-levering removes the debt-driven financial risk, leaving an asset beta that represents the underlying operating risk of the business. This makes it possible to compare how risky the actual business is across firms with different levels of debt. Re-levering then applies the target capital structure to that asset beta, producing a levered beta that matches the firm’s intended mix of debt and equity. This levered beta is what you use in the CAPM to estimate the cost of equity. In short, un-levering isolates business risk for comparison, and re-levering adjusts that risk to the company’s own financing, which is why this process is used.