Why do you unlever and relever beta?

Observed beta reflects both business risk and the financial risk of that specific company's leverage. Unlevering strips out the capital structure to isolate business risk, which is comparable across peers. Relevering applies your subject company's target capital structure. Skipping the step means importing your comps' balance sheets into your valuation.

Should WACC use the current or target capital structure?

Target. WACC discounts cash flows over the entire forecast and into perpetuity, so it needs the structure the company is expected to maintain, not a snapshot that may be temporarily distorted. Using today's structure for a company mid-deleveraging bakes a transient leverage ratio into a perpetual discount rate.

Why use market values rather than book values for the weights?

Cost of capital is the return investors require on what they could sell their claim for today, which is a market value. Book equity is an accounting residual that can be negative or decades stale. Debt is often close enough at book, but equity must be market capitalization.

How do you estimate cost of equity for a private company?

Build it from public comps. Unlever the peer group's betas, take a median, relever at the private company's target structure, then run CAPM. Practitioners typically add a size premium and sometimes a company-specific premium, since a small private business carries risks a large-cap index does not capture.

DCF

WACC and beta (Advanced)

By Michael Song · Wharton MBA · ex-Greenhill · investment banking interview coach

4 min read · updated July 30, 2026

The basic articles give you CAPM and the WACC formula. Level 4 and 5 questions attack the inputs — because that is where every real disagreement about a valuation actually lives.

Unlevering and relevering, done properly

A beta you pull off a screen is a levered beta. It reflects two things mixed together: the underlying business risk, and the financial risk created by that specific company's capital structure. Only the first is comparable across peers.

$\beta_U = \frac{\beta_L}{1 + (1 - t)\frac{D}{E}} \qquad\qquad \beta_L = \beta_U \left[1 + (1 - t)\frac{D}{E}\right]$

Worked, because the arithmetic is where people slip. A comp has a levered beta of 1.40, debt-to-equity of 0.60, tax rate 25%. Unlevered: $1.40 / [1 + 0.75 \times 0.60] = 1.40 / 1.45 =$ 0.966.

Your subject company targets a 0.30 debt-to-equity. Relevered: $0.966 \times [1 + 0.75 \times 0.30] = 0.966 \times 1.225 =$ 1.18.

That drop from 1.40 to 1.18 is not cosmetic. At a 5.5% equity risk premium, it moves cost of equity by roughly 120 basis points, which moves a DCF materially.

Key insight

The $(1 - t)$ term is doing real economic work, not sitting there for decoration. Debt creates a tax shield, so leverage raises equity risk by less than the raw debt-to-equity ratio suggests. Omit the tax factor and you systematically over-relever, inflate cost of equity, and undervalue every levered company you look at.

Target structure, not today's

WACC discounts cash flows across the forecast and into perpetuity, so it needs the capital structure the company is expected to sustain — not whatever the balance sheet happened to show last quarter.

The case that makes this obvious: a company that just closed a large debt-funded acquisition is sitting at 2.0x debt-to-equity today and has publicly committed to deleveraging to 0.5x over three years. Use today's 2.0x and you relever beta to a number that assumes the company stays maximally levered forever, inflating cost of equity and then, through the weights, distorting WACC in the other direction. Neither error offsets the other cleanly.

Use the target, and say why out loud. If no target is stated, the industry median from your comp set is the defensible fallback.

Common mistake

The mechanical errors, in the order they cost people offers. Book values for the weights — cost of capital is about what investors require on what they could sell today, so equity must be market capitalization, never book equity, which is an accounting residual that can even be negative. Forgetting to after-tax the cost of debt — WACC uses $r_D(1 - t)$ because interest is deductible; using the pre-tax coupon overstates WACC directly. Using the coupon rate as the cost of debt — the cost of debt is the yield on the company's debt today, and for a distressed borrower the coupon and the yield are nowhere near each other. Mismatching the risk-free rate to the cash flows — a long-dated DCF wants the 10-year or 20-year government yield, not a T-bill.

Cash-adjusted beta and the private company problem

Two refinements that come up in level 5 questions.

Cash-adjusted (or unlevered-for-cash) beta. A company holding a large cash balance is effectively a levered bet on its operating business plus a risk-free asset. That cash dampens observed beta. If a comp holds 30% of its market cap in cash, its screened beta understates the business risk you're trying to isolate, and practitioners adjust using net debt rather than gross debt to partially handle it.

Private companies. There is no observable beta, so you build one: unlever the peer group's betas, take the median rather than the mean so one outlier can't drive your answer, relever at the target structure, then run CAPM. Practitioners then typically add a size premium, on the argument that a small private business carries risks a large-cap index doesn't capture, and sometimes a company-specific premium for key-man or customer concentration. Be able to name those additions and to say plainly that they are judgment rather than theory, because that honesty is what an interviewer is listening for.

Interview tip

If asked to build a WACC from scratch, narrate the sequence and flag each judgment call: pull comp levered betas, unlever each at its own capital structure and tax rate, take the median, relever at the subject's target structure, run CAPM for cost of equity, take cost of debt as the current yield after tax, then weight at market values. Ten steps, spoken cleanly, with "I'd use the target structure here because this company is mid-deleveraging" as the aside. The aside is what gets remembered.

Glossary

New to the lingo? Every term used above, in plain English.

Cost of equity: The return shareholders require to own a company stock, given its risk. Usually estimated with CAPM, and it is always higher than the cost of debt.
Cost of debt: The rate a company pays to borrow. Because interest is tax-deductible, the after-tax cost of debt is what goes into WACC, and it is cheaper than equity.
Risk-free rate: The return on an investment with essentially no risk, usually the yield on a long-term government bond. It is the starting point for the cost of equity.
Equity risk premium (ERP): The extra return investors demand for holding stocks instead of risk-free government bonds. Historically it runs around 5% to 7%.
Capital structure: The mix of debt and equity a company uses to fund itself. More debt is cheaper but riskier, and finding the right balance affects both value and risk.
Leverage ratio: How much debt a company carries relative to its earnings, usually measured as debt divided by EBITDA. Higher leverage means more risk and more required debt paydown.
Tax shield: The tax a company saves because an expense is deductible. Depreciation, for example, lowers taxable income, so it saves cash on taxes even though it is non-cash.
Net debt: A company total debt minus its cash. It is what you subtract from enterprise value to get to equity value, since a buyer could use the cash to pay down the debt.
Market capitalization: The total value of a public company shares, calculated as share price times the number of shares outstanding. It is the same thing as equity value for a public company.
Private equity (PE): Firms that raise money to buy whole companies, improve them over several years, and sell them for a profit. They often use large amounts of borrowed money to do it.

Frequently asked

Why do you unlever and relever beta?: Observed beta reflects both business risk and the financial risk of that specific company's leverage. Unlevering strips out the capital structure to isolate business risk, which is comparable across peers. Relevering applies your subject company's target capital structure. Skipping the step means importing your comps' balance sheets into your valuation.
Should WACC use the current or target capital structure?: Target. WACC discounts cash flows over the entire forecast and into perpetuity, so it needs the structure the company is expected to maintain, not a snapshot that may be temporarily distorted. Using today's structure for a company mid-deleveraging bakes a transient leverage ratio into a perpetual discount rate.
Why use market values rather than book values for the weights?: Cost of capital is the return investors require on what they could sell their claim for today, which is a market value. Book equity is an accounting residual that can be negative or decades stale. Debt is often close enough at book, but equity must be market capitalization.
How do you estimate cost of equity for a private company?: Build it from public comps. Unlever the peer group's betas, take a median, relever at the private company's target structure, then run CAPM. Practitioners typically add a size premium and sometimes a company-specific premium, since a small private business carries risks a large-cap index does not capture.

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