Why is it necessary to un-lever and re-lever Beta in the Cost of Equity calculation?

• A. To average out the risk across all companies
• B. To reflect the company's unique capital structure
• C. To account for industry-specific risks
• D. To simplify the financial model

Answer: (B)

The necessity to un-lever and re-lever Beta in the calculation of the Cost of Equity stems from the need to reflect the company's unique capital structure. Beta represents the volatility or risk of an asset in relation to the market as a whole, and it is influenced by whether a company is financed by debt (leverage) or equity.

When a company's capital structure includes debt, its equity Beta will differ from the asset Beta (un-levered Beta) because the financial risk associated with leverage affects the equity Beta. Un-levering the Beta removes the effects of leverage, allowing you to obtain the pure risk associated with the company's assets without the influence of its capital structure. Once the analysis is tailored to the underlying business risk, re-levering adjusts the Beta back to reflect the current capital structure of the company being analyzed. This process helps in calculating the Cost of Equity accurately, ensuring that the risk profiles and returns expected by equity investors are based on the actual financial risks presented by that specific company.

In this context, while other options pertain to risk, simplification, or averaging, they do not directly address the specific need to adjust for the capital structure in determining the correct Cost of Equity that reflects the company’s actual risk exposure