Walk me through unlevering and relevering beta (the Hamada adjustment) and why you do it when using comparable companies.
An advanced Valuation question — expect it in final rounds and case-heavy interviews (IB, PE, Big-4 Transaction Services).
THE SHORT ANSWER
Observed (levered/equity) betas of comparable companies reflect both business risk and their individual capital structures, so you can't use a peer's raw beta directly for a target with different leverage. You unlever each comp's beta to strip out its financial risk — βu = βL / (1 + (1−tax)·D/E) — leaving asset (business) risk only. You then take a representative unlevered beta (often the median) and relever it at the target's own target capital structure: βL = βu · (1 + (1−tax)·D/E). That gives a beta consistent with how you intend to finance the target, which feeds the cost of equity in WACC. The point is comparability: you're isolating pure business risk from the peers and re-applying your subject company's leverage, rather than importing someone else's balance sheet.
WHAT INTERVIEWERS LISTEN FOR
- ✓Observed beta mixes business and financial risk
- ✓Unlever each comp: βu = βL/(1+(1−t)D/E)
- ✓Take median βu, relever at target's capital structure
- ✓Ensures beta matches the target's intended leverage
COMMON MISTAKES
- ✗Using a peer's levered beta directly
- ✗Forgetting the (1−tax) term
- ✗Relevering at the comp's leverage not the target's
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