Unlevered Beta & Re-Levering

When calculating WACC for a DCF valuation, you need beta — a measure of systematic risk. But you can't just use one comparable company's beta because its capital structure is different from your target's. The solution: unlever each comparable's beta to strip out the leverage effect, take the median unlevered beta as a proxy for pure industry business risk, then re-lever it using the target's own capital structure. This ensures the beta you use in the cost of equity calculation reflects the right business risk and the right financial risk.

The Hamada equation (derived by Robert Hamada in 1972) provides the mathematical relationship between levered and unlevered beta. The unlevering formula is: βU = βL / [1 + (1−t)(D/E)], where t is the tax rate and D/E is the debt-to-equity ratio. To re-lever: βL = βU × [1 + (1−t)(D/E)]. The (1−t) factor accounts for the tax deductibility of interest — debt increases risk but also provides a tax shield, so the net effect is dampened by the tax rate. Some practitioners use the Fernandez formula or other variants, but Hamada is the standard in investment banking interviews and most practical applications.

Step 1: Identify 5-10 public comparable companies for your target. Step 2: Pull each comparable's levered beta (typically 2-year weekly or 5-year monthly regression against the S&P 500). Step 3: Gather each comparable's D/E ratio (using market value of equity and book or market value of debt) and marginal tax rate. Step 4: Unlever each comparable's beta using the Hamada equation. Step 5: Take the median (or mean) of the unlevered betas — this represents the industry's pure business risk. Step 6: Re-lever this median unlevered beta using the target company's assumed capital structure and tax rate. Step 7: Plug the re-levered beta into CAPM to calculate cost of equity, then into WACC.