Debt beta is the result of the ratio of credit spread and market risk premium. If it is taken into account, the company value usually increases.
Definition of Debt Beta
Debt beta is a measure of the sensitivity of equity to changes in debt financing and is the result of the ratio of credit spread and market risk premium. It is therefore also an indicator of systematic risk within the meaning of CAPM.
The debt beta in valuation
The consideration of debt beta is still not widespread in valuation practice, and has recently been increasingly discussed against the background of the practical advice of IDW 2/2018. From the point of view of valuation theory, on the other hand, there is little new to report; the opinion here has always been clearly in favour of taking debt beta into account. The reason for this is that the assumption of fail-safe borrowed capital, which ultimately allows debt beta to be omitted, usually proves to be out of touch with reality.
Why is it necessary to apply a debt beta?
As part of the derivation of equity costs using the CAPM in conjunction with Modigliani/ Miller, fail-safe debt capital is usually assumed in the standard case. Even with excellent AAA and AA ratings, this premise is by no means guaranteed. This makes it all the less likely that typical ratings are in the A to B range from A to B. In fact, lenders almost always assume part of the operational risk, which is compensated by the loan premium. The amount of risk assumed depends on the financing mix and the corresponding debt sustainability of the company.
Since the amount of a company's total operational risk is now independent of financing, at least within the ranges of typical debt ratios (exception: the existence of so-called indirect insolvency costs), the assumption of risks by the lender reduces the risk of equity providers. Without an application of debt beta, which represents the assumed default risk of debt financing, the unlevered beta of equity providers would be overestimated with the risk of an undervaluation of the valuation object. The reason for this is ultimately that the default risk would then be taken into account both in the loan premium and in the beta factor of equity providers.
Unlevering and relevering with Debt Beta
For unlevering and relevering the beta factor taking into account debt beta, the formulas, assuming a secure tax shield, are as follows:
If an insecure tax shield is assumed, the formulas for unlevering and relevering the beta factor are simplified, the following applies:
Even though this is already apparent from the above formula, it should be expressly pointed out once again that “uncertain tax shield” and “debt beta” describe various issues. While debt beta is linked to the resilience of borrowed capital, the Tax Shield basically refers to the security of tax savings from external financing. In addition to a possible default of borrowed capital, this includes in particular the amount and proportion of borrowed capital as a financing component over time.
Alternative methods for deriving debt beta
One of the reasons for the comparatively low acceptance of debt beta in valuation practice is the lack of availability of good empirical data. This, in turn, is due to the fact that, in addition to some advantages, possible survey approaches always have disadvantages that require the evaluator to be positioned.
The following presentation of these advantages and disadvantages relates to the primary application in the context of determining unlevered beta for a valuation property using a group of listed comparative companies.
- Direct derivation from returns on listed bonds: This form of derivation offers the advantage that it is based on directly observable market data from comparable companies, i.e. the prices and returns of the listed bonds of the respective company. On the other hand, there are some serious disadvantages. Initially, not all of these companies placed listed bonds on the capital market; the external financing of many companies is often provided by private placements, bank financing, etc. Even in the event that a company has listed bonds on the market, trading is often thin, even with high-volume issues, with correspondingly high bid-ask spreads. In addition, every bond issued by one and the same company is always characterized by its own specific characteristics, including the term, currency, securities, repayment modalities, etc.
- Direct rating-based derivation: Various providers provide data tables which can be used to directly read and apply a rating-specific average debt beta using the ratings of the comparable companies without having to make further adjustments. This form of derivation is simple and is based on valid static data. However, it proves to be a disadvantage that only blue chip and companies with higher financing requirements have a rating from the three major agencies Moody's, S&P and Fitch and have this issued regularly. This is not surprising due to the high costs of the rating, but significantly limits the group of available comparable companies with determinable debt beta.
- Indirect shadow rating-based derivation from credit spreads: This approach does not rely on an official rating from the three major rating agencies, but determines a so-called shadow rating on the basis of various financial figures, industry affiliation and other rating-specific factors. This can be used to derive debt beta for each company using rating-specific credit premiums and empirical surveys on the share of systematic CAPM-relevant risk in the credit premium. This approach allows all comparable companies to determine debt betas using an even more uniform methodology, but requires a detailed financial analysis typical of a rating.
All three approaches have advantages and disadvantages. Depending on the peer group and the associated data availability, the evaluator must decide which of the three approaches is the best in the specific application case.
Practical advice from IDW 2/2018 and expert opinion from KFS/BW 1
The concept of debt beta has recently found its way into standard setting. In practical note 02/2018, IDW takes up the concept of debt beta. In its expert report, the KFS/ BW 1 has already suggested the use of a debt beta as soon as the borrowing costs of the valuation object are at the risk-free interest rate.
Debt beta has recently found its way into valuation practice and standard setting, so that it is recommended to use it in many cases of company valuation in future. As part of the empirical determination of debt beta, the evaluator has the choice between various empirical survey approaches, but must make sacrifices in terms of analysis effort and/or availability.