Question

You have been asked to value the assets of a privately held consulting company. You can use the capital asset pricing model to estimate the equity paid us for every firm in this industry and then compute the average equity beta. You noticed that firms in this industry have significantly different capital structures. You told your boss that this average equity beta is the appropriate beta to use for the valuation of the consulting companies assets. Should your boss agree with you? Why or why not? If not what alternative approach would you recommend? Explain

Answer 1

Your boss will disagree with you. In this case, the average of equity betas of firms in the industry is not the correct beta, since they have significantly different capital structures i.e. different mix of equity and debt financing or different degrees of financial leverage.

The correct approach would be to ungear or unlever the equity betas of the industry firms which would give their unlevered betas or asset betas. The asset beta is the beta of an entity on the assumption that it uses only equity financing (thus, "standardising the capital structures" for the purpose of comparison). The formula for unlevering the equity beta and calculating the asset beta is:

Asset Beta = equity beta / (1+(1-taxrate)*(debt/equity ratio))

Once the asset betas of all industry firms are calculated, the next step would be to take an average of all of them.

After calculating the average asset beta of industry firms, the final step would be to regear the asset beta with the capital structure of the privately-held subject company and calculate its regeared equity beta using the above formula (plug in the average asset beta calculated above).