Levered vs Unlevered Beta, Explained
The question
Explain what beta measures and why an observed equity (levered) beta blends business risk and financial risk. Why can't you directly compare the levered betas of two companies with different capital structures?
General educational practice only. This is not an actual, confidential, leaked, or firm-provided interview question. Check important technical details against primary learning materials.
The answer
Beta measures a stock’s sensitivity to the overall market’s returns. The observed equity, or levered, beta blends two distinct risks: business risk, the cyclicality and volatility of the underlying operations, and financial risk, the amplification that debt adds. Debt is a fixed claim, so more leverage makes equity returns swing more dramatically for any given move in operating performance.
That means the levered beta rises with leverage even if the business itself hasn’t changed. So you can’t directly compare levered betas of two companies with different capital structures because each beta is contaminated by that company’s own debt load. Two identical businesses with different debt levels will show different equity betas purely due to financing, not operations.
To make a fair comparison, you must first unlever each company’s beta using its own debt-to-equity ratio and tax rate, stripping out the financial risk to isolate the pure business, or asset, beta. Then you can average those asset betas and re-lever at your target’s structure. The unlevered beta is always lower than the levered beta because leverage only adds risk. That’s why you never average levered betas directly.
DCF timeline
| Line item | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Free cash flow | 50 | 54 | 58 | 63 | 68 |
| PV of free cash flow | 45 | 45 | 44 | 43 | 42 |
| Terminal value (Year 5 exit) | 1,001 |
| PV of terminal value | 621 |
| Implied enterprise value | 840 |
Also asked as
- Write the unlevering (Hamada) formula and explain, term by term, why the denominator has the shape 1 + (1 - Tax) x (D/E), in particular why the (1 - Tax) term is there.
- A comp has a levered beta of 1.25, D/E of 0.50, and a 25% tax rate. Compute its unlevered beta, and use the direction sanity check to confirm your answer is sensible.
- Walk through the complete six-step workflow for building a cost of equity for a private company with no observable beta, being explicit about which company's D/E you use at the unlever step versus the re-lever step and why.
- Two comps: A has levered beta 1.10 at D/E 0.30; B has levered beta 1.55 at D/E 1.40; both at 25% tax. Unlever both, and explain which underlying business is actually riskier and why the levered betas were misleading.
- You're given a target capital structure as 30% debt of total capital, tax rate 25%, and an average asset beta of 0.95. Re-lever the beta, then compute the cost of equity with a 4% risk-free rate and 5.5% equity risk premium. Show the D/(D+E)-to-D/E conversion explicitly.
- Explain the key assumptions embedded in the standard Hamada unlevering formula (debt beta, constant leverage, tax shield risk) and describe one situation where each assumption breaks and would lead you to a different formula or input.
- Elite: A comp has levered beta 1.45, book D/E of 1.00, and trades at 2.0x book equity; tax rate 25%. Correct the D/E to market value, unlever the beta, then re-lever it for a target that will run a 0.60 market D/E at 25% tax. Compute the target's equity beta and state how much the book-vs-market error would have distorted the result.
- Elite: A highly levered comp has an equity beta of 1.80, a market D/E of 1.50, a tax rate of 25%, and risky debt with an estimated debt beta of 0.20. Unlever using the full formula that includes debt beta, then compare to the naive zero-debt-beta unlevering, and explain the direction and economic reason for the difference.
- Elite: Build a full WACC for a private target. Comps' unlevered betas average 0.88. Target will run D/E of 0.667 (i.e., 40% debt of total capital), tax rate 25%, pre-tax cost of debt 7.0%, risk-free rate 4.2%, equity risk premium 5.0%. Re-lever the beta, compute cost of equity, after-tax cost of debt, and WACC. Then state how WACC would change if the target instead ran zero debt, and why the beta piece moves.
Practice this topic with rubric-grounded grading inside IB Atlas.
Start freeGet all 125 practice prompts as one PDF.
General educational prompts with study explanations for offline review. They are not firm-provided or confidential questions.
Keep going
The rest of this topic
Beta: levered, unlevered, relevered