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What Is Unlevered Cost of Capital?
Let me explain unlevered cost of capital directly: it's an analysis that uses either a hypothetical or actual debt-free scenario to measure a company's cost to implement a particular capital project, and sometimes to assess the entire company. You should know that unlevered cost of capital compares the project's cost using zero debt against a levered cost of capital investment, which involves using debt as part of the total capital required.
Key Takeaways
Here's what you need to grasp: unlevered cost of capital is that analysis in a debt-free scenario measuring project implementation costs. It directly compares zero-debt options to levered ones with debt. Remember, unlevered cost is generally higher than levered because debt costs less than equity. To calculate it, you'll need unlevered beta, market risk premium, and the risk-free rate of return. If a company doesn't meet anticipated unlevered returns, investors might reject the investment. Generally, a higher unlevered cost of capital indicates higher risk for a stock, assuming other factors are constant.
Understanding Unlevered Cost of Capital
When a company needs to raise capital for expansion or other reasons, you have two main options: debt financing, which means borrowing through loans or bonds, or equity financing, which involves issuing stock.
I want you to understand that unlevered cost of capital is generally higher than levered because debt is cheaper than equity—borrowing money costs less than selling company equity, especially with tax benefits on interest expenses. Sure, levered projects have costs like underwriting, brokerage fees, and coupon payments, but over the project's life or the firm's operations, these are marginal compared to the benefits of lower debt costs versus equity.
Importantly, unlevered cost of capital determines the cost of a specific project, separating it from procurement costs. It represents the cost of financing the project without debt, providing an implied rate of return that helps you as an investor make decisions. If the company fails to meet anticipated unlevered returns, you might reject the investment. Typically, if you see a stock as high-risk, it's because of a higher unlevered cost of capital, all else equal.
There's also the weighted average cost of capital (WACC), another formula you and companies use to check if an investment is worth it. WACC considers the entire capital structure, including common stock, preferred stock, bonds, and other long-term debt.
Formula and Calculation of Unlevered Cost of Capital
To calculate unlevered cost of capital, you need several factors: unlevered beta, market risk premium, and the risk-free rate of return. This calculation serves as a standard to measure investment soundness.
Unlevered beta shows an investment's volatility compared to the market—it's also called asset beta, determined by comparing to similar companies with known levered betas, often averaging multiple betas for an estimate. Market risk premium is the difference between expected market returns and the risk-free rate.
Once you have all variables, calculate unlevered cost of capital with this formula: Unlevered Cost of Capital = Risk-Free Rate + Unlevered Beta * (Market Risk Premium).
If the result is higher than the company's return, conduct further analysis. Comparing it to the cost of debt helps determine if incurring debt and using leverage will lower total capital costs, including equity and debt.
How Do You Calculate Unlevered Cost of Capital?
You calculate unlevered cost of capital by multiplying unlevered beta and market risk premium, then adding that to the risk-free rate. Unlevered beta is the investment's volatility, and market risk premium is the difference between expected market returns and the risk-free rate. The formula is Unlevered Cost of Capital = Risk-Free Rate + Unlevered Beta * (Market Risk Premium).
Is a Higher or Lower Unlevered Cost of Capital Better?
A lower unlevered cost of capital is better because it indicates lower risk. For you as an investor, a lower unlevered cost makes the investment more attractive—it generates returns with less risk and avoids debt financing complexities.
What Is Levered vs. Unlevered Capital?
Levered capital is borrowed money, like a loan, involving debt financing. Unlevered capital isn't borrowed—it's the enterprise's own money through equity financing. Companies can use either debt or equity to grow and fund projects, each with pros and cons, and you must balance both for successful operations.
The Bottom Line
Unlevered cost of capital analyzes a company's ability to finance a project without debt, giving insight into cost structure in a debt-free scenario. Since debt is cheaper than equity, unlevered cost is usually higher than levered. Companies use this metric to evaluate investments, considering risks and costs. If unlevered cost is too high, it signals higher risk. By comparing to debt costs, companies can decide if leveraging reduces overall capital costs.
