Unlevered/Re-Levered Beta Walk: The Full Mechanics

The classic Hamada equation assumes that the debt itself is risk-free (i.e., debt beta = 0), which is fine for investment-grade firms but understates equity beta for LBO-style or distressed targets where debt is genuinely risky. For high-yield-rated targets, use the Modigliani-Miller variant: equity_beta = asset_beta + (asset_beta - debt_beta) (D/E) (1 - t). Pick a debt beta of 0.15-0.25 for BB-rated paper and 0.30-0.50 for B-rated or CCC, sourced from spread-decomposition studies. Practitioners who skip this adjustment systematically under-estimate cost of equity on leveraged targets by 50-150 bps.

When the target capital structure is itself a model output — for example, in an LBO model where projected leverage falls as debt is paid down each year — the re-levered beta should change YEAR BY YEAR alongside the changing D/E. This is the iterative-WACC problem: the discount rate depends on capital structure, capital structure depends on projected free cash flow, free cash flow depends on the discount rate via DCF math. Practitioners typically resolve this with either (a) a fixed long-run target D/E held constant across the forecast period (simplest, defensible for a steady-state company), or (b) a year-by-year WACC schedule that re-levers beta against the projected D/E in each forecast year (most rigorous for an LBO or a recapitalization). Method (a) is mathematically wrong but practically OK for mature businesses; method (b) is correct but adds modeling complexity and surfaces the circularity (since changing WACC changes projected FCF, which changes the year-by-year D/E, which changes WACC). Most institutional models settle this by either explicitly using APV (which sidesteps the WACC circularity entirely) or by accepting the small error from method (a).

Going Deeper — three traps in the unlever / re-lever walk that bite at the senior-analyst level. (1) Tax-rate consistency: if any peer is in a different tax jurisdiction or carries large NOLs, its effective tax rate is not the same as the statutory rate the formula assumes. Either normalize each peer to the same statutory rate before unlevering or use each peer's effective rate explicitly. (2) Operating leases: post-ASC 842 (effective 2019), operating leases sit on the balance sheet as right-of-use assets / lease liabilities. Some practitioners include lease liabilities in the D/E used for unlevering (treating them as quasi-debt); others do not. The convention matters and must be applied consistently across all peers. (3) Negative net debt: tech firms with large cash piles can have NEGATIVE net debt at the moment of observation, which makes the unlever formula produce an equity beta LOWER than the asset beta — mathematically defensible but practically odd. Most analysts floor net debt at zero for the unlever step on cash-rich firms, on the argument that excess cash is sitting in Treasuries and is not a financing source supporting the operating business. AI prompt: 'For this ticker, pull the observed equity beta, the effective tax rate, the D/E ratio, and the lease-liability balance. Walk me through the unlever step and tell me what asset beta this firm contributes to a peer-set average.'