In a discounted cash flow (DCF) analysis, how does one typically adjust beta for a company's capital structure?

In a discounted cash flow (DCF) analysis, the process of adjusting beta for a company's capital structure primarily involves the concept of relevering beta. This is rooted in the Modigliani-Miller theorem, which suggests that a company’s beta can be adjusted to reflect different levels of debt in its capital structure.

Relevering involves using the median unlevered beta, which represents a company's risk without the impact of debt (i.e., the equity risk only). To adjust for the company's actual capital structure, the unlevered beta is then relevered. This is done by applying the company's debt-to-equity ratio, considering the tax shield from interest on debt, which impacts the overall risk profile of the equity. Therefore, the calculation incorporates the proportionate weight of equity and debt to derive the levered beta, which is used in the DCF analysis to account for the financial risk introduced by leverage.

This approach accurately reflects how risk changes with fluctuations in capital structure, making it essential for a comprehensive DCF model that aims to yield a realistic assessment of a company’s value.