Business Finance involves a number of different metrics. Beta is considered to be one of the most important concepts in business finance. As a matter of fact, Beta is defined as a measure of volatility that a business faces with respect to other factors. Furthermore, it encapsulates the systematic risk of an underlying security or portfolio. The main usage of Debt Beta is under Capital Asset Pricing Model. The CAPM model signifies and describes the existing relationship between systematic risk as well as expected return for assets. Depending on the capital structure of the company, there are two broad categories of beta: levered beta and unlevered beta.
On one hand, it can be seen that Levered Beta measures the market risk that the company is exposed to. Since it captures the elements involved in the market, it is also referred to as equity beta. On the contrary, as far as unlevered beta is concerned, it does not factor in debt. This is to mainly eradicate the risk that exists because of company’s assets.
Speaking of debt beta, it is assumed to be zero when calculating levered beta because debt is considered to be risk-free, unlike equity. Where debt beta is not considered to be zero, then it is included in the calculation. It reflects the fact that there is an inherent systematic risk of the debt which needs to be factored in.
Debt beta is used in case of calculating beta of the firm. It is used in the following formula:
Asset Beta = Equity Beta / (1+ [(1 – Applicable Tax Rate) (ratio of debt to equity)]
Unlevered Beta = Asset Beta (in the case where the company assumes no leverage)
Levered Beta = Levered Beta / (1 + [(1 – Tax Rate) (debt/equity)]
A company’s gearing ratio is directly proportional to the beta calculation. Factually, both levered, and unlevered beta are representative of the stock volatility in conjunction with the overall market. Regardless, it can be analyzed that levered beta implies that as the company continues to take on more and more debt, it’s market volatility considerably increases. This is primarily because of the fact that it reflects the risk that the business has taken on by stacking up more debt.
Despite the fact that debt beta (or consider it insignificant) is not always used by companies, but it is still considered a very important metric. This is more applicable in the case of highly leveraged companies. This implies that debt beta and its interpretation is really important for organizations because it helps them to analyze their risk profiles accordingly.
Calculation of debt beta is considered to be important for companies on a number of grounds. The main advantages include:
- Calculation of debt beta is considered an important phenomenon because it works out in favor of almost all the stakeholders, primarily the investors as well as the creditors. This is because it encapsulates why all the inherent risks included with debt and their subsequent correlation with market volatility.
- The capital structure of the company also provides some useful insights, which help the company to make strategic risk decisions in the future.
- Calculation of debt beta helps companies decide on the perfect capital structure, and how they should ideally make changes in their capital structure to align themselves with their risk policy.
Given the fact that debt beta is considered to be a highly important metric, yet there are a couple of pitfalls of debt beta that need to be accounted for. They are as follows:
- Calculation of Debt Beta is considered to be a complex task. In most cases, the chances of error are quite substantial, and hence, this is something that needs to be incorporated in the overall analysis.
- Calculation of Debt Beta is considered redundant primarily because of the fact that it is assumed to be risk-free. The results might be skewed from the perspective of the company depending on how lowly or highly geared the company is.
- In the case where debt is customized, and there are numerous different stakes involved, debt beta cannot be entirely resourceful. This is because risk in itself can never be accurately encapsulated in real terms. In that case, Debt Beta does not prove to be as effective.
Therefore, it can be seen that a debt beta is an important tool that forms the basis for a variety of different transactions within the company. In this regard, it imperative to consider the fact that even if it fails to accurately incorporate the exact results, it still is a resourceful metric.