Corporate Finance.

Calculating weighted average

cost of capital-WACC.
Relevering Beta
DEC 30, 2010BY

JAWWAD FARID IN BETA

Relevering Beta
When assessing the value of a companys operations free cash flows need to be
discounted using the weighted average cost of capital (WACC). WACC or weighted
average cost of capital is calculated using the cost of equity and cost of debt weighting
them by their respective proportions within the optimal or target capital structure of the
company, i.e.

WACC = E/(D+E)*Cost of Equity + D/(D+E) * Cost of Debt, where E is the market value
of equity, D is the market value of Debt.

The target or optimal capital structure of the company is one where WACC is minimized
which would result in the maximization of shareholders wealth.

The cost of debt can be observed from bond market yields. However the cost of equity
may be estimated using the Capital Asset Pricing Model (CAPM) formula, specifically

Cost of Equity = Risk free Rate + Beta * Market Risk Premium

Beta in the formula above is equity or levered beta which reflects the capital structure of
the company. The levered beta has two components of risk, business risk and
financial risk.

Business risk represents the uncertainty in the projection of the companys cash
flows which leads to uncertainty in its operating profit and subsequently uncertainty in its
capital investment requirements.
Financial risk represents the additional risk placed on the common shareholders as
a result of the companys decision to use debt, i.e. financial leverage. This is because
with the addition of more debt to the structure the residual claim of the shareholders
becomes less certain and hence more risky.
If the capital structure comprised of 100% equity then beta would only reflect business
risk. This beta would be unlevered as there is no debt in the capital structure. It may
also be known as the asset beta.
To obtain the equity beta of a particular company, we start of first with the portfolio of
assets of that company or alternatively a sample of publicly traded firms with a similar
systematic risk. We will first derive the betas of these individual assets or firms from
market prices. The derived betas are levered betas as they would reflect the capital
structure of the respective firms. They would need to be unlevered so as to only reflect
their business risk components.
From the unlevered betas a weighted average unlevered beta will be obtained using as
weights the proportions of the assets in the companys asset portfolio or an average
across all comparable firms will be derived. The weighted unlevered beta thus obtained
would now be re-levered based on the capital structure of the company in order to
determine the equity or levered beta for the company, a beta that reflects not only the
business risk but also the financial risk of the company.

Un-levering and re-levering beta may be done in a number of ways. A method employed
by practitioners gives the relationship between un-levered and re-levered beta as
follows:

Levered Beta = Unlevered Beta * (1+D/E), where D/E = Debt-to-Equity Ratio of the
company.

The practitioners method makes an assumption that the corporate debt is risk free. If
corporate debt is considered risky then another possible formulation is:

Levered Beta = Asset Beta + (Asset Beta Debt Beta) * (D/E) where Debt Beta is
estimated from the risk free rate, bond yields and market risk premium.

The above formulations do not incorporate the impact of corporate taxation, i.e. the fact
that debt returns tend to be tax deductible. In order to consider the impact of taxation
the following adjustments will be made in the relationships given above:
Under the practitioners method:
Levered Beta = Unlevered Beta * (1+D*(1-T)/E) where T is the tax rate.
Under the risky-debt formulation:
Levered Beta = Asset Beta + (Asset Beta Debt Beta) * (D/E)*(1-T).

And WACC would be equal to E/(D+E)*Cost of Equity + D*(1-T)/(D+E) * Cost of Debt.

Relevering Beta Example

NewCorp is a corporation of personal hygiene and medical subsidiaries. We are
estimating its levered beta for the purpose of determining its cost of equity. The personal
hygiene subsidiary is worth USD 20 million while the medical subsidiary is worth USD
30 million. The firm has a debt-to-equity ratio of 1. The tax rate for all firms is assumed
to be 30%. The risk free rate is 7% and the market risk premium is 6%. The following
information has been obtained of firms with comparable systematic risk:

Comparable Firms

Average Beta

Average D/E Ratio

Personal Hygiene

0.9

20%

Medical

1.2

60%

Note that the average betas above denote the average of the levered or
equity betas of these firms.
In the first step we will calculated the unlevered betas for each group of firms using the
practitioners method:

Unlevered Beta for the personal hygiene business = 0.9 / (1+ 0.2*(1-0.3)) = 0.79

Unlevered Beta for the medical business = 1.2 / (1+ 0.6*(1-0.3)) = 0.85

We will then calculate the unlevered beta for NewCorp. This will be the weighted
average of unlevered betas where the weights are taken in proportion to the
subsidiaries value in the firm, i.e.

Unlevered Beta for NewCorp = 0.79*20m/50m+0.85*30m/50m = 0.82

Levered Beta for NewCorp = 0.82*(1+1*(1-0.3)) = 1.40

Cost of Equity = 7%+1.40*6% = 15.39%.

Also see Calculating Beta with respect to Market Indices.