Unlevered Cost of Capital

Unlevered cost of capital is the theoretical cost of a company financing itself for implementation of a capital project, assuming no debt.

The unlevered cost of capital is a numerical figure, expressed as a rate. A company which wants to undertake a project will have to generate capital or money for it. Theoretically the capital has to be generated either through debt or through equity. There might be reasons for the company to avoid raising capital through debt and incur cost and future liability.

This tentativeness pushes the company to go for equity model for capital generation. A hypothetical calculation is performed to determine the required rate of capital. This numerical figure or capital is the equity returns an investor expects the company to generate to justify an investment in stock. In reality, however, this number is just an assumption. Real figures cannot be given.

The theoretical unlevered cost of capital is calculated using a formula. This gives an approximate of the likely requirement of the market.

Calculating Unlevered Cost of Capital

To calculate a company’s unlevered cost of capital the following information is required:

  • Risk free Rate of Return
  • Unlevered beta
  • The Market Risk Premium

Calculation of the firm’s risk premium is done by multiplying the company’s unlevered beta with the difference between expected market returns and the risk free rate of return. Expected market returns less risk free rate is also known as the market risk premium.

Beta is the volatility of the firm versus the market, is therefore an adjustment of risk over a period of time. The unlevered beta removes the effects of leverage from the company’s beta.

Formula

Unlevered Cost of Capital = Risk Free Rate + Unlevered Beta x (Expected Market Return – Risk Free Rate)

This points to the theory that a company will have a higher unlevered cost of capital if investors perceive the stock as being higher risk.

Unlevered Cost of Capital When There Is Debt

Ignoring the debt component and its cost is essential to calculate the company’s unlevered cost of capital, even though the company may actually have debt.

Now if the unlevered cost of capital is found to be 10% and company has debt at a cost of just 5% then its actual cost of capital will be lower than the 10% unlevered cost of capital. This unlevered cost of capital is still informative, but if the company fails to achieve the 10% unlevered returns that investors in this market require, then investor capital may move to alternative investments. This will lead to fall in the company’s stock price.

More Reading