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The published beta factors seen above were based on historical data.

These beta factors are driven by two elements:

Business risk Financial risk.

The business risk refl ects factors such as the level of operational leverage (fi xed costs versus variable costs); whether the business produces necessities or luxuries; whether the business’s customers are public sector or private sector; how highly regulated the sector is; among other factors.

The other key element is the fi nancial risk, or leverage. If the target capital structure that is used for the WACC calculation (see below) is different to the existing capital structure (i.e. the capital structure for the period over which the published beta factor was calculated), then the published beta factor may not be relevant for the valuation.

It is necessary to adjust the beta factor to take into account the target capital structure. This can be done in two stages:

De-lever the published beta factor to remove the effect of the existing fi nancial leverage. This gives us an unlevered, or asset, beta factor.

⎡ ⎣ ⎡

1 + (1 – T)

⎣

e.g.

= 0.62

Stage 1 – de-levering the beta factor

D

βu = Unlevered beta factor βL = Levered beta factor t = Tax rate

N.B. The above assumes the beta of debt is zero 0.8

Re-lever this asset beta to incorporate the target capital structure.

This gives us a levered, or equity, beta factor.

⎡ ⎣ ⎡

1 + (1 – T)

⎣

e.g.

= 0.9

Stage 2 – re-levering the beta factor D

βu = Unlevered beta factor βL = Levered beta factor t = Tax rate

N.B. The above assumes the beta of debt is zero

Target capital structure

A similar approach can be taken when valuing private companies, which do not have published beta factors. A universe of comparable listed companies can be selected, their published beta factors de-levered for their existing capital structure and re-levered for the private company’s target capital structure, and an average then taken.

The version illustrated above is a slight simplifi cation, as it assumes that the debt fi nance of the business has a beta factor of zero. This is consistent with the approach seen in many textbooks (e.g. Damodaran, Fernandez and others). See the “Advanced DCF Valuation” chapter of this manual for a fuller discussion of this process.

The following should clarify the alternative terminology used for beta factors:

Terminology

Weighting

Once a cost of debt and a cost of equity are established, they must be blended together to produce a weighted average cost of capital. The key question that arises is the proportions of debt and equity funding to be used for this process. The following options are available:

Current book values of debt and equity Current market values of debt and equity Target book values of debt and equity Target market values of debt and equity Optimal capital structure.

The merits of each of these will be addressed in turn:

Current book values of debt and equity

The advantage of using the current book values of debt and equity is that they are known numbers, in that they can be found in the balance sheet of the business to be valued. However, the disadvantage of this is that it shows the existing position, rather than being forward-looking.

Also, the balance sheet numbers are affected by differences in generally accepted accounting principles (GAAP). For example, under IFRS, convertible bonds are split into the debt portion, which is presented as a liability, and the equity portion, which is presented within equity. Under US GAAP, the full amount is shown as a liability (see “Accounting and analysis for investment bankers”, for further detail).

Different GAAP could lead to different weighting proportions being used in the WACC calculation, even though there is no underlying difference in the economic reality. Therefore, trading values must be used.

Current market values of debt and equity

Using market values of debt and equity avoids the accounting issues discussed above. However, this option presents other problems:

Market values of debt and equity will only be available for listed businesses When they are available, they still show a current rather than a forward-looking position

Market values suffer from volatility, which then leads to the issue of whether an average should be used. If so, what sort of average and over what period (again, historical rather than forecast)?

For these reasons, the current market values of debt and equity are often best avoided as well.

Target book values of debt and equity

If a forward-looking target capital structure is to be used it makes sense to think of this in market value terms (debt and equity as proportions of total enterprise value), rather than accounting, or book values.

Target market values of debt and equity

Using target market values of debt and equity is possible if the existing management has announced such a target or if a prospective management team envisages a particular capital structure. This is the preferred approach.

If no such announcement has been made or there is no clear preference, defaulting to the sector average capital structure can provide the solution.

A key driver of how much a business can gear up is its ability to generate cash. Since it is reasonable to expect businesses in the same sector to have similar cash-generative characteristics, their levels of leverage will converge over time.

Therefore, even if the business being valued does not currently share the sector average capital structure, it should tend towards this position in the long run.

Optimal capital structure

The use of an optimal capital structure has several advantages over the use of book or market values of debt and equity:

It is forward looking

It is not affected by accounting judgements It is not affected by market volatility.

However, although theories regarding the optimal capital structure do exist (e.g. those of Modigliani and Miller), calculating it in practice often proves diffi cult and the situation can still change over time. Also, there is no certainty that the business will follow this fi nancial strategy.

•

Book value Market value

Current ✘ ✘

Target ✘ ✔

Optimal Problematic