Levered vs Unlevered Beta

Beta you pull from Bloomberg or Yahoo is levered (equity) beta — it bakes in that company's specific debt load. Debt amplifies equity risk: a company with more leverage has a higher equity beta even if its underlying business is identical to a debt-free peer, because fixed interest payments make equity returns more volatile. So if you grabbed a heavily-levered comp's beta and applied it to a lightly-levered target, you'd overstate risk and cost of equity. The fix is to un-lever every comp's beta to a common, debt-free basis (asset beta), which isolates the risk of the business itself.

Step 1: For each comparable company, take its levered beta and un-lever it using its own debt/equity and tax rate. Step 2: Take the median (or mean) unlevered beta across the comps — this is your estimate of pure business risk for the sector. Step 3: Re-lever that median unlevered beta using your TARGET company's debt/equity and tax rate. The result is a levered beta tailored to your target, which you then drop into CAPM. This three-step dance ensures the only thing carried over from the comps is business risk, while the capital-structure risk reflects your specific company.

The (1 + (1 − tax) × D/E) term reflects the tax shield on debt. Because interest is tax-deductible, debt's risk-amplifying effect on equity is dampened by the tax benefit — so the formula scales the D/E impact by (1 − tax rate). This is the Hamada equation. A subtle point interviewers love: the formula assumes debt beta is zero (debt is risk-free), which slightly overstates equity beta for highly distressed firms with risky debt, but it's the standard simplifying assumption used in practice.