Pitfalls in Levering and Unlevering Beta and Cost of Capital Estimates in DCF Valuations


  • Robert W. Holthausen,

    1. ROBERT W. HOLTHAUSEN is the Ernst and Young Professor and the Nomura Securities Professor of Accounting and Finance, as well as Chair of the Accounting Department, at the University of Pennsylvania's Wharton School of Business. Bob's research has studied the effects of management compensation and governance structures on firm performance, the effects of information on volume and prices, corporate restructuring and valuation, the effects of large block sales on common stock prices, and numerous other topics.
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  • Mark E. Zmijewski

    1. MARK E. ZMIJEWSKI is the Leon Carroll Marshall Professor of Accounting at The University of Chicago's Booth School of Business. The focus of Mark's extensive academic writings and consulting are issues related to valuation, security analysis, and the effect of financial and other disclosures on capital market participants and security prices.
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  • This article is based on on Chapters 10 and 12 of Corporate Valuation: Theory, Practice and Evidence, by Robert Holthausen and Mark Zmijewski, © 2012, Cambridge Business Publishers.


The “levering” and “unlevering” of estimates of beta and various costs of capital are routine steps in estimating the discount rates used in DCF valuations. But as the authors demonstrate by reviewing the existing research on the subject, the levering and unlevering formulas that are most commonly used in practice are not appropriate for valuing many companies. They also illustrate the shortcomings of—and substantial valuation errors that can result from—the common practices of assuming that the betas of securities like debt and preferred stock are equal to zero and ignoring the effects of equity-linked securities such as employee stock options, warrants, and convertible debt.

The authors offer alternative levering formulas that are more appropriate for valuing most companies than—and as readily implemented as—the formulas commonly used today. They also provide a relatively easy way to estimate betas for debt and preferred stock that can be used in the levering and unlevering formulas. The authors discuss how properly to account for equity-linked securities such as employee stock options, warrants, and convertible debt while demonstrating the potential importance of ignoring such equity-linked securities in the levering and unlevering formulas. Finally, the authors show why it is appropriate to standardize the treatment of contractual obligations such as leases across comparable companies in order to get consistent estimates of the unlevered cost of capital.