Unlevered cost of capital is an analysis that uses a hypothetical or an actual debt-free scenario to measure a company’s cost to implement a particular capital project. This method compares the project\u2019s cost of capital using zero debt to an alternative levered cost of capital, which incorporates debt into the total capital required.
Key Takeaways
- Unlevered cost of capital estimates a company\u2019s expense of a capital project without using debt.
- This calculation is usually higher than the levered cost of capital due to debt’s lower cost compared to equity.
- Calculating unlevered cost of capital involves factors such as unlevered beta, market risk premium, and the risk-free rate of return.
- If the anticipated unlevered returns are not met, investors may reconsider their investment.
- A higher unlevered cost of capital generally signifies higher investment risk.
The Core Principle of Unlevered Cost of Capital
When a company aims to raise capital for expansion or other needs, it often turns to two primary options:
- Debt Financing: This involves borrowing funds through loans or bond issuances.
- Equity Financing: This involves raising funds by issuing additional stock.
Unlevered cost of capital is typically higher than levered cost due to the relative expenses. Borrowing funds is less costly than forfeiting a stake in the company through equity issuance. Levered projects incur costs such as underwriting, brokerage fees, and coupon payments, yet such fees are usually offset by the lower cost of debt over time.
Importance and Application
Unlevered cost of capital calculation isolates the cost of a specific project, removing procurement costs. This metric provides an accurate rate of return, aiding investors in making well-informed decisions. Should the company fail to meet predicted unlevered returns, potential investments can be declined. Typically, a higher unlevered cost of capital indicates a higher risk stock.
Another tool used by investors and companies is the Weighted Average Cost of Capital (WACC)\u2014a formula encompassing the company\u2019s complete capital structure, including common and preferred stock, bonds, and additional long-term debt.
Formula and Calculation Explained
Several elements are vital for calculating the unlevered cost of capital, such as unlevered beta, market risk premium, and the risk-free rate of return, enabling a reliable measurement of investment soundness.
ta represents the volatility of an investment compared to the broader market, determined by averaging multiple betas of similar companies with known metrics. Market risk premium is the difference between expected market returns and the risk-free rate of return.
With known variables, use the following formula:
Unlevered Cost of Capital = Risk-Free Rate + Unlevered Beta * (Market Risk Premium)
If the result exceeds the company’s return, it necessitates further examination. Comparing the calculated cost with the company\u2019s debt cost helps reveal potential leverage benefits, optimizing overall capital mix including both equity and debt.
Related Terms: Cost of Capital, Debt Financing, Equity Financing, Weighted Average Cost of Capital, Market Risk Premium, Beta.
References
- FDIC. “Fueling Your Business: A Guide to Financing Your Small Business”, Pages 6-9.
