What is Levered Beta in Corporate Finance?

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Levered beta indicates the systematic risk a stock has in the capital asset pricing model (CAPM). In CAPM, the function of the financial debt versus equity represents the levered beta or equity beta.

  • The debt a company collects from the markets and the equity it has in its reservoir make up the comparison that shows the levered beta of a stock.

  • The debt portion of an investment in a project that has been resourced from the market makes big difference in the financials of the project.

  • If a large amount of debt is used to finance a project, the risks associated with the investment go high. In other words, the magnitude of debt a company owes in comparison to its equity holdings is the key factor in the levered beta of the stock of a company.

How Does Levered Beta Work?

The equity beta of a stock is usually used to compare the stock's risk in relation to the market risks. There are various micro and macroeconomic factors that influence the risks of a stock. To account for these risks, equity beta is used as a measure of the volatility of the stock in the capital markets.

  • In general, an equity beta equal to 1 is considered to indicate that the risk of the project is equal to the market risk.

  • A beta less than 1 shows a lower risk of a stock than the market risk.

  • A beta value more than 1 indicates that the risk of the project is more than that of the market risk.

Usually, for a fund that has a debt portion, the removal of the debt component from the risk factor provides the equity beta value of a stock. It means that, as more equity is used for funding a project, the value of the stock of a company gets stronger.

  • In general, terms, using internal resources rather than debt that is resourced from the market is an indication of the wellbeing of a company. That is why, self-equity-financing is considered to be the best option for financing a project and this is reflected in the performance of a stock in the market.

  • Equity beta is related to the performance of the stock in terms of the removal of risk. The more debt a stock has in its underlying position, the more will be its equity beta and vice versa. Usually, levered beta is calculated from the unlevered beta by a function and a stock's debt-to-equity ratio.

The calculation of equity beta is the key to estimating the profitability of a stock's performance and it is a vital part of the capital asset pricing model.

raja
Updated on 20-Jan-2022 10:38:49

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