Why must you use market-value D/E rather than book D/E when re-levering beta?
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
You must use market-value D/E because beta itself is a market-based measure of risk. It's derived from stock prices and market returns, so the capital structure you plug into the Hamada formula has to reflect how the market views the company's leverage, not an accounting residual. Book equity is a historical cost number that distorts the true financial risk that equity holders face.
If I used book D/E, I'd be mixing an accounting metric with a market metric, and the re-levered beta would misprice the risk. The market value of debt and equity captures current financial risk and the actual economic claims on the firm, which is exactly what beta is measuring.
So when I unlever peer betas and then re-lever at the target's structure, market-value D/E keeps the entire chain consistent and grounded in the same market-based framework.
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 |
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The rest of this topic
Beta: levered, unlevered, relevered