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What is Asset Beta or Unlevered Beta?
The asset beta or unlevered beta of the assets of a company is a representation of the systematic risks of the assets. The asset beta is the weighted average of debt beta and equity beta of the assets. It is also called unlevered beta because it can be determined from the equity beta.
To determine the unlevered beta, the equity beta has to be divided by a factor 1 plus (1 minus tax rate) times the debt-to-equity ratio of the company. That is,
$$\mathrm{Unlevered \:Beta\:=\:\frac{Equity\: Beta}{1+[(1-Tax \:rate)\times(\mbox{Debt-Equity} \:Ratio)]}}$$
Asset Beta and Systematic Risk
Asset beta also has a direct impact on the systematic risk exposure of a company. Asset beta essentially neutralizes the effect of capital structure on a company's exposure to the systematic risk of the company. It can be used to check the true systematic risk of its assets and not just the equity of the company.
The Miller and Modigliani approach suggests that the cost of equity is proportional to the debt-to-equity ratio of a company. That is, the cost of equity increases with the increase in the debt-to-equity ratio. The same happens to the asset beta of a company.
With higher debt, the company's stock return increases with the increase in market returns of a stock. It is important to remove the excess systematic risk that comes into the exposure to debt. Asset beta is the amount of systematic risk that remains after the additional risk from the debt is removed from the resulting debt.
Estimating Asset Beta using Pure-Play Method
Asset beta is an important part of the pure-play method. The method is used to calculate the cost of equity. It is done by unlevering the publicly available equity beta value of a company using comparable firm debt-to-equity ratio to get the asset beta which is then re-levered utilizing the debt-to-equity ratio of the company under analysis.
To estimate asset beta using the pure-play method −
Select comparable companies in the listed companies of the market.
Estimate the beta for comparable companies.
The beta obtained is unlevered removing the effect of financial leverage. This is, the beta that represents the business risk of assets. That is why, it is called asset beta.
Uses of Asset Beta
It is used to assess the risk of security removing the debt of a company.
It can be used to check the performance of a company with respect to the market situation without impacting the company's debt.
It does not include the effect of financial leverage. It is extensively used in financial modeling, business valuation and investment banking, and equity research.
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