Recent Study on a Simulated Debt-Beta

In the September issue of “BewertungsPraktiker”, Matthias Meitner, Felix Streitferdt, and Lothar Streitferdt published an article on the bottom-up deduction of a debt-beta.  The debt beta is the central component in a method to derive the market value of external capital analogously how it is typically done for equity capital.  In practice, three methods are regularly applied in attempts to quantify a debt beta: calculation as actuarial return, direct adjustment of the yield, and regression analysis.  All of these methods, however, are connected with substantial implementation issues, including the determination of the default rate, complex and sensitive calculation, and lack of reliable empirical data.  To avoid these issues, the author conducted a simulation analysis to clarify the fundamental characteristics that a realistic debt beta should have.  This simulation was conducted in three steps: simulation of the value of a hypothetically 100% equity financed business, split of the total value into the values of equity and debt, and calculation of the debt beta.  The simulation comprised 10’000 combinations of business value and market portfolio with an assumed correlation between market return and business value as well as between market portfolio and business return of 0.5 each.  The results indicate, among other things, that an increase of the financial leverage increases both the equity and the debt beta and that the debt beta will approach the value of the unlevered equity-beta.  A main conclusion of the authors is that the debt beta is determined endogenously by the parameters of the unlevered business, the value of the tax-shield, and the financial leverage.

In our experience, discussions around business valuations in a transfer pricing context will typically not touch the valuation of any given debt financing.  Typically, the nominal debt amount is assumed equal to the market value.  The article illustrates why this is a reasonable assumption in practice, as reliable methods to quantify the debt beta are currently still lacking.  The study also may be used as a starting point for sensitivity analyses that explore a possible effect of reasonable debt betas.  Such sensitivity analyses may, in the right circumstances, be helpful to further substantiate simplifying assumptions.  The article also emphasizes that commonly applied rules-of-thumb for debt betas are regularly leading to false results and should be avoided.

The article by Meitner, Streitferdt, and Streitferdt was published in “BewertungsPraktiker” Nr. 3 of 28 September 2020 on pages 62 through 68.