Beta is a measure of systematic risk. However, Levered Beta incorporates the impact of Capital Structure of a firm, and Capital Structure is an Internal Factor of a company [and hence, Capital Structure and Debt-Equity Ratio (Financial Risk) should be covered under unsystematic risk]
So, is it fair to say that Unlevered Beta is a “truer” (and better) representative of systematic risk of a company as compared to Levered Beta ? And that Levered Beta has a little bit of Unsystematic Risk since it incorporates the impact of Capital Structure (Debt-Equity Ratio) of a Company ?
Also, while calculating Systematic Risk (Beta^2*Variance of Market), is it better to use Unlevered Beta (instead of Levered Beta) ?
Also, since CAPM assumes that unsystematic risk has been killed via Diversification (through investment in Market Portfolio) and only systematic risk is left, is it technically and conceptually better to use Unlevered Beta (instead of Levered Beta) in CAPM to calculate Required Rate of Return [Re = Rf + (Rm-Rf)Beta]
Your point is very correct and a good point. See when we incorporate financial leverage and make unlevered beta into unlevered beta so we are trying to match the my company with other company in the economy having that similar kind of leverage. So using unlevered beta and levered beta doesn’t matter. Because one assumption of CAPM also says that Investors has homogenous expectation so they are taking into account whether they are investing in levered company or unlevered company. If every investor is investing in levered company because of homogenous expectation assumption so that financial leverage part is covered means unsystematic risk reduced. So your point is correct its just that when beta is calculated it has been seen that all such factors gets eliminated.
In CAPM World, all Investors invest in Market Portfolio, but IF Financial Leverage is a part of Market Portfolio itself, that means every investor is exposed to this risk and it can’t be killed through diversification, so in a way, it becomes a part of Systematic Risk only, and is NO Longer a part of unsystematic risk.
Is the above mentioned Logic Correct ?
I dont think so its correct. The reason behind the same is that when you are implying about financial leverage it is for a specific company and it can be killed through diversification. Lets say you invested in a company with very low financial leverage and a company with high financial leverage so you are almost in the balance. Although it is not entirely correct to say that but the essence remains the same. I hope you got that.