Unlevered Cost of Capital

What Is Unlevered Cost of Capital?

Unlevered cost of capital is an analysis utilizing either a theoretical or a genuine debt-free scenario to measure a company's cost to carry out a specific capital project (and at times used to evaluate a whole company). Unlevered cost of capital compares the cost of capital of the project involving zero debt as an alternative to a levered cost of capital investment, and that means involving debt as a portion of the total capital required.

Figuring out Unlevered Cost of Capital

At the point when a company needs to raise capital for expansion or different reasons it has two options: (1) debt financing, which is to borrow money through loans or bond issuances, or (2) equity financing, which is the issuance of stock

The unlevered cost of capital is generally higher than the levered cost of capital in light of the fact that the cost of debt is lower than the cost of equity. Borrowing money is less expensive than selling equity in the company. This is true given the tax benefit connected with the interest expense paid on the debt. There are costs associated with levered projects including underwriting costs, brokerage fees, and coupon payments, be that as it may.

By and by, over the life of the capital project or the firm's continuous business operations, these costs are marginal compared to the benefits from the lower cost of debt compared to the cost of equity.

Significant

The unlevered cost of capital can be utilized to determine the cost of a specific project, isolating it from procurement costs.

The unlevered cost of capital addresses the cost of a company financing the actual project without causing debt. It gives an implied rate of return, which assists investors with pursuing informed choices on whether to invest. On the off chance that a company neglects to meet the anticipated unlevered returns, investors might dismiss the investment. As a rule, on the off chance that an investor accepts a stock is a high risk, it will regularly be on the grounds that it has a higher unlevered cost of capital, different viewpoints being steady.

The weighted average cost of capital (WACC) is one more formula that investors and companies use to determine whether an investment is worth the cost. WACC thinks about the whole capital structure of a firm, which incorporates common stock, preferred stock, bonds, and some other long-term debt.

Formula and Calculation of Unlevered Cost of Capital

Several factors are important to work out the unlevered cost of capital, which incorporates unlevered beta, market risk premium, and the risk-free rate of return. This calculation can be utilized as a standard for measuring the sufficiency of the investment.

The unlevered beta addresses an investment's volatility as compared to the market. The unlevered beta, otherwise called asset beta, is determined by contrasting the company with comparable companies with known levered betas, frequently by utilizing an average of different betas to infer an estimate. The calculation of market risk premium is the difference between expected market returns and the risk-free rate of return.

When all factors are known, the unlevered cost of capital can be calculated with the formula:

Unlevered Cost of Capital = Risk-Free Rate + Unlevered Beta (Market Risk Premium)

Assuming that the consequence of the calculation creates an unlevered cost of capital of 10%, and the company's return falls below that amount, then it may not be an insightful investment. Correlation of the outcome to the current cost of company-held debt can determine the genuine returns.

Highlights

• Unlevered cost of capital is an analysis utilizing either a speculative or a genuine debt-free scenario to measure a company's cost to execute a specific capital project.
• Unlevered cost of capital compares the cost of capital of the project involving zero debt as an alternative to a levered cost of capital investment.
• The unlevered cost of capital is generally higher than the levered cost of capital on the grounds that the cost of debt is lower than the cost of equity.
• Several factors are important to compute the unlevered cost of capital, which incorporates unlevered beta, market risk premium, and the risk-free rate of return.
• On the off chance that a company neglects to meet the anticipated unlevered returns, investors might dismiss the investment.
• As a rule, on the off chance that an investor accepts a stock is high-risk, it will normally be on the grounds that it has a higher unlevered cost of capital, different perspectives being consistent.