When using the CAPM for

purposes of calculating WACC,

why do you have to unlever and
then relever Beta?
In order to use the CAPM to calculate our cost of equity, we need to estimate the appropriate
Beta. We typically get the appropriate Beta from our comparable companies (often the
mean or median Beta). However before we can use this industry Beta we must first
unlever the Beta of each of our comps. The Beta that we will get (say from Bloomberg or
Barra) will be a levered Beta.
Recall what Beta is: in simple terms, how risky a stock is relative to the market. Other
things being equal, stocks of companies that have debt are somewhat more risky that stocks
of companies without debt (or that have less debt). This is because even a small amount of
debt increases the risk of bankruptcy and also because any obligation to pay interest
represents funds that cannot be used for running and growing the business. In other words,
debt reduces the flexibility of management which makes owning equity in the company
more risky.
Now, in order to use the Betas of the comps to conclude an appropriate Beta for the
company we are valuing, we must first strip out the impact of debt from the comps Betas.
This is known as unlevering Beta. After unlevering the Betas, we can now use the
appropriate industry Beta (e.g. the mean of the comps unlevered Betas) and relever it for
the appropriate capital structure of the company being valued. After relevering, we can use
the levered Beta in the CAPM formula to calculate cost of equity.

The case "Marriott Corporation: The Cost of Capital (Abridged)" focuses on an

ideal opportunity to review the capital asset pricing model and the weighted
average cost of capital through calculation of the cost of capital for Marriott as a
whole. Dan Cohrs is faced with making recommendations for the hurdle rates at
Marriott Corporation and its three divisions utilizing CAPM and WACC. This case
illustrates how to calculate beta based on comparable companies and to lever
betas to adjust for capital structure; the appropriate risk-less rate and market risk
premium; the choice of time period to estimate expected returns and the
difference between the geometric and the arithmetic average as a measure of
expected returns.

J. Willard Marriott started Marriott Corporation in 1927 with a root beer stand, expanding it into a leading lodging
and food service company with sales of over $6 billion by 1987. At the time, Marriott had three main lines of
business, lodging, contract services and restaurants, with lodging generating about 51% of
companys profits. The four key elements of Marriotts financial strategy were managing hotel
assets rather than owning, investing in projects with the goal of increasing shareholder value, optimizing the use of

debt, and repurchasing their undervalued shares. Marriott Corporation relied on measuring the opportunity
cost of capital for investments by utilizing the concept of Weighted Average Cost of Capital (WACC). In April
1988, VP of project finance, Dan Cohrs suggested that the divisional hurdle rates at the company would
have a key impact on their future financial and operating strategies. Marriott intended to continue its growth at a
fast pace by relying on the best opportunities arising from their lodging, contract services and restaurants lines of
businesses. To make the company managers more involved in its financial strategies, Marriott also considered
using the hurdle rates for determining the incentive compensations.