Debt beta is a measure of the sensitivity of equity to changes in debt financing and is derived from the ratio of the credit spread to the equity risk premium. It serves as an indicator of systematic risk as defined by the Capital Asset Pricing Model (CAPM).
Debt beta is a measure of the sensitivity of equity to changes in debt financing and is derived from the ratio of the credit spread to the equity risk premium. It serves as an indicator of systematic risk as defined by the Capital Asset Pricing Model (CAPM).
The consideration of a debt beta is still not very common in valuation practice, but is increasingly being discussed in light of the IDW 2/2018 practice note. In valuation theory, the consideration of a debt beta has always been advocated, as the assumption of default-proof debt is often unrealistic.
When deriving the cost of equity using the CAPM, default-proof Debt is usually assumed for the standard case. This premise is not always given, even with excellent ratings in the AAA and AA range. Lenders almost always assume part of the operational risk, which is compensated for by the credit spreads. This risk must be taken into account in the valuation in order to avoid an overvaluation of the unlevered beta and thus an undervaluation of the company.
The formulas for unlevering and relevering the beta factors, taking into account the debt beta and assuming a safe tax shield, are as follows:
Simplified formulas apply for an uncertain tax shield:
It is important to note that "uncertain tax shield" and "debt beta" refer to different concepts. Debt beta refers to the certainty of default of the debt, while the tax shield refers to the certainty of tax savings from the debt financing.
One of the reasons for the low acceptance of debt beta in valuation practice is the lack of availability of good empirical data. The following presentation describes the advantages and disadvantages of various approaches to determining the debt beta:
The evaluator must decide which approach is most suitable depending on the peer group and the availability of data.
The concept of debt beta has found its way into standard setting. IDW Practice Note 02/2018 takes up the concept of debt beta, as does the expert opinion of KFS/BW 1, which recommends the application of a debt beta as soon as the borrowing costs of the valuation object exceed the risk-free interest rate.
Debt beta has recently found its way into valuation practice and standard setting, which is why its application is recommended in many cases of business valuation. The empirical determination of debt beta requires a choice between different data collection approaches, which have advantages and disadvantages depending on the analysis effort and data availability. smartZebra's tools and expertise can help to make this process efficient and ensure accurate valuations.
