Definition
Beta can simply be defined as a measure of volatility, or systematic risk of an underlying security, or portfolio. It is used in Capital Asset Pricing Model which mainly describes the existing relationship between systematic risk as well as expected return for assets. There are two main kinds of beta, levered beta, and unlevered beta.
Levered Beta measures the market risk. It is also referred to as equity beta. In this regard, both debt and equity are factored in when a company’s risk profile is assessed.
On the other hand, as far as unleveled beta is concerned, it involves ignoring the debt component, in order to isolate the risk that exists because of the company’s assets.
As far as debt beta is concerned, it can be seen that it is considered to be zero when calculating levered beta because debt is considered to be risk free as compared to equity investment.
Therefore, it is assumed to be zero when calculating the asset beta. In the case where debt beta is not zero, then it is factored in the calculation. It implies that there is an inherent systematic risk of the debt.
Formula
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 – Tax Rate) (debt/equity)]
Subsequently, levered or unlevered beta is calculated using the asset beta, and if the company wants to include debt in the calculation or not. In the case of calculating levered beta:
Unlevered Beta = Asset Beta (in the case where the company assumes no leverage)
Levered Beta = Levered Beta / (1 + [(1 – Tax Rate) (debt/equity)]
Explanation
A company’s debt level greatly impacts its beta. This is the calculation that investors make when they are calculating ways to measure the volatility of the security or the portfolio.
It can be seen that both levered, and unlevered beta show the volatility of the stock to the overall market. However, levered beta shows that the more debt that a company has, the more volatile it is in relation to the market movements.
This is because of the fact that it is representative of the risk of leveraging that the business has undertaken over the course of time.
Therefore, although companies don’t often use debt beta (or consider it insignificant), yet it can be seen that it is a really important metric, especially in the case of highly leveraged companies.
Therefore, debt beta, its interpretation is really important for organizations because it helps them to devise risk profiles based on these metrics.
Additionally, these metrics are also really resourceful for investors, because they can subsequently decide their investment portfolios based on the risk they want to take.
Advantages
Calculation of debt beta proves to be advantageous for companies on the following grounds:
- Including debt in the overall analysis helps organizations as well as stakeholders to incorporate for debt that they have undertaken.
- This plays out in favor of everyone involved, primarily because of the reason that it accounts for the inherent risks included with debt, in line with market volatility.
- Debt Beta provides an insight in accordance with the debt-equity firm of the company. Even in the case where the company is not highly leveraged, it helps to include useful information regarding the debt fluctuations.
- Debt Beta is referred to as one of the most important metrics that is used by investors. In case this is not used, they might not be well aware of the underlying volatility of the stock due to market changes.
Disadvantages
Regardless of the fact that debt beta has a numerous different advantages, yet it has certain limitations that cannot be ignored.
- Firstly, it can be seen that debt beta might not always be accurately calculated. The calculation needs to be done with extreme caution, otherwise, it might result in skewed results.
- Debt Beta is often insignificant – that is why it is assumed to be risk free. Incorporating it might not always be the right approach in the case where the company is low-geared because it might skew the results. Volatility as a result of market fluctuations cannot be properly captured in this regard.
- Debt Beta is only reliable in the case where the debt has a contingency, on a certain event that might take place in the future. In other cases, it is often treated as a relatively safe and stable asset source.
- Debt beta might not capture the full picture of the risk profile, and hence this might lead to results being affected.