Unlevered betas and cost of capital: an empirical approach

Purpose: Current study investigates the significance of financial leverage in computation of systematic risk within the context of CAPM model. Key literature/theoretical perspective: We contribute to the literature by providing empirical evidence on two different issues of Unlevered Betas ( βu). First, whether assumptions such as growth rate, target leverage, and the proper rate of discounting tax shields affect ( βu). Second, whether utilizing the basic idea behind βu would help to overcome the information shortfalls in calculating the cost of capital for non-traded firms. Findings: Preliminary findings are consistent with the majority of previous studies and suggest that the use of the Levered Proxy Betas to solve the lack of market information for both non-traded firms and individual business units is not misleading. Although the relation is stronger for market values, book values of equity also show statistical significant relationship. This is good news for practitioners who have been using the unleveraged approach for years without many lights about the validity of their specific procedures. The results also show that the Modigliani-Miller (1958, 1963) assumption regarding the inclusion of tax effect in the unlevered beta calculation has a more statistical performance than the Miles and Ezzel (1985) with the market-based beta and also their results are closer to the theoretical expected result of one. Practical and social implications: Our study helps financial practitioners such as Investment Bankers and firm valuators, who have been using the unleveraged approach for years without many lights about the validity of their specific procedures.