Beta and Leverage1 The theoretical link between levered and unlevered equity betas depends on the link

between the value of the levered firm and the value of the unlevered firm. In the theorys simplest form, M&M assume risk-free, perpetual debt and show that this link is given by the following equation: VL = VU + TD = D + E (1)

Definition of Variables: E,L and U are the betas of levered and unlevered equity (unlevered asset beta), respectively. T is the corporate tax rate. VU and VL are the values of the levered and unlevered firms, respectively. D and E are the values of debt and equity, respectively. Equation (1) assumes away all complications of financial distress and possible differences in information between managers and financial markets. The beta of the entire levered firm (note that this is not the same as the beta of the equity of the levered firm, but rather levered asset beta) can be written as the weighted average of the beta of debt (in this case, zero since the debt is risk-free) and the beta of the levered equity: [D / (D+E)] (0) + [E / (D + E)] (E,L) (2)

In addition, the beta of the entire levered firm can be expressed as the weighted average of the beta of the unlevered firm and the beta of the tax shield (in this case, zero since the tax shield is certain): [VU / VL] (U) + [TD / VL] (0) (3)

In equation (3), the weight of the tax shield is based on its contribution to firm value. Since both equation (2) and equation (3) represent the same thing (the beta of the entire levered firm), we can set the two equal to one another. Using equation (1) to express VU in terms of the other variables and rearranging terms yield equation (4): E,L = U[1 + D (1 T) / E] This equation can also be used to get unlevered beta as: U = E,L / [1 + D (1 T) / E] (5) (4)

Divisional Beta: If a corporation has distinct business divisions then we can write equation for unlevered beta (U) as a function of divisional betas and their respective weights. U = (U,Division 1)(WeightDivision 1)+(U, Division 2)(WeightDivision 2)+ (6) Once divisional unlevered beta is determined from the above equation we need to re-lever divisional beta to get divisional levered beta. Equation 4 should be used for that computation.

For another treatment, see Ross, Westerfield, and Jaffe, Corporate Finance, 4th ed. (New York: Richard D. Irwin, 1996), 469.

The Effect of Leverage on the Value of the Firm: As mentioned before Equation (1) assumes that all complications of financial distress and possible differences in information between managers and financial markets are irrelevant. In reality, these effects are significant to fully ignore especially when debt levels are relatively high. We can adjust Equation (1) to reflect the effects of these costs as: VL = VU + TD C C reflects costs of bankruptcy and financial distress. (7)