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Hi, Why is it important to find out levered beta and unlevered beta?. Is levered beta used in the CAPM model for estimating the cost of equity? . Does adding debt in the capital structure increases the overall levered beta of the firm?. What can we really interpret from levered beta?
Are you sure that you meant to ask this in the P7 forum and not in the P4 forum??
The levered beta (or share beta, or geared beta) measures the riskiness of a share in the company, and yes – it is this beta that is used to estimate the cost of equity (because the return required by shareholders (and hence the cost of equity) is determined by the riskiness of the share.
The risk in a share is due partly to the riskiness of the business itself, but is increased due to the gearing in the business. The more gearing there is, the greater the risk for shareholders, and therefore the greater the geared (share) beta.
The unlevered beta (or ungeared beta, or asset beta) measure the riskiness of the actual business.
Increasing the gearing of the business (adding more debt) increases the riskiness of the share, and therefore increases the levered (geared) beta.
(Strictly, it is not the firm that has the geared beta but the share in the firm)
(‘Leverage’; ‘levered betas etc tend to be the words used in the US. In the exam we tend to refer to ‘gearing’; geared betas etc..)
So by raising debt the financial risk of the shareholders increases and as a result there is a change in the overall systematic risk of the firm which is represented by the Beta, Is my thought correct?
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