What is the 'Unlevered Cost Of Capital'

The unlevered cost of capital is an evaluation that uses either a hypothetical or actual debt-free scenario when measuring the cost to a firm to implement a particular capital project. The unlevered cost of capital should illustrate that it is a cheaper alternative than a levered cost of capital investment program. It is a variation of the cost of capital calculation.

BREAKING DOWN 'Unlevered Cost Of Capital'

An unlevered cost of capital is a cheaper alternative to a levered cost of capital investment, as there are higher costs associated with the issuing of debt or preferred equity. Some of these marginal costs include underwriting costs, brokerage fees, and dividend and coupon payments.

The unlevered cost of capital represents the cost of a company financing itself without any debt. Though hypothetical, this provides an idea of the expected equity returns a company may generate, helping an investor determine if investing in the particular stock is justified. If a company fails to meet the anticipated unlevered returns, investors may choose to move their investments elsewhere.

The unlevered cost of capital can also be used to determine the cost of a particular project, separating it from procurement costs.

Factors in Calculation of the Unlevered Cost of Capital

To make the calculation, the beta of the investment must be determined. The beta is a representation of the volatility of a particular stock or investment over time. The beta can be calculated by comparing the company to other similar ones with known levered betas, often by using an average, or mean, of multiple betas to come to an estimate. The averaged levered beta will need to be converted to an unlevered beta by removing the effects of financial leverage.

Other market factors, such as the risk-free rate and the expected market return, are also required for calculating the unlevered cost of capital. Once those variables are known, the unlevered cost of capital can be calculated with the following formula:

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

The output can then be used as a standard to which an investment can be measured. If the result of the calculation produces an unlevered cost of capital of 10%, and the company's return falls below that amount, then it may not be a wise investment. This can also be compared to the current cost of debt held by the company to determine the actual returns.

RELATED TERMS
  1. Unlevered Beta

    A type of metric that compares the risk of an unlevered company ...
  2. Unlevered Free Cash Flow - UFCF

    A company's cash flow before interest payments are taken into ...
  3. Homemade Leverage

    A substitution of risks that investors may undergo in order to ...
  4. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
  5. Cost Of Equity

    In financial theory, the return that stockholders require for ...
  6. Incremental Cost Of Capital

    A term used in capital budgeting, the incremental cost of capital ...
Related Articles
  1. Investing

    Understanding Levered And Unlevered Free Cash Flow

    Levered cash flow is the money a business has after meeting its financial obligations. Unlevered free cash flow is the money a business has before paying its financial obligations.
  2. Investing

    Unlevered Beta

    Learn about how this number provides a measure of how much systematic risk a firm's equity has compared to the market.
  3. Investing

    How To Calculate Beta Of A Private Company

    We explain two methods for calculating the beta of a private company.
  4. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  5. Investing

    Beta: Know The Risk

    Beta says something about price risk, but how much does it say about fundamental risk factors? Find out here.
  6. Investing

    Beta: Gauging Price Fluctuations

    Learn how to properly use this measure that can help you meet your criteria for risk.
  7. Financial Advisor

    Calculating Beta: Portfolio Math For The Average Investor

    Beta is a useful tool for calculating risk, but the formulas provided online aren't specific to you. Learn how to make your own.
  8. Investing

    Valuing Private Companies

    Even though they’re typically not accessible to the average investor, private firms often raise money through venture capital or private equity investments.
  9. Investing

    High Beta – Low Beta Stocks Define Volatility Trades

    We compare the Beta values obtained from financial sources. Also, how to compute Beta using Excel.
  10. Investing

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
RELATED FAQS
  1. How should investors interpret unlevered beta?

    Learn what unlevered beta is, how it is calculated, and how investors can interpret the unlevered betas of companies within ... Read Answer >>
  2. What are the practical uses for unlevered beta?

    Understand the practical uses for a security's unlevered beta, and learn why investors should rely on a security's unlevered ... Read Answer >>
  3. How do I unlever beta?

    Learn how to calculate the unlevered beta of a company and understand the differences between standard beta versus unlevered ... Read Answer >>
  4. How does unlevered beta help in risk management?

    Find out how unlevered beta can be used in risk identification and management, specifically as it relates to the CAPM valuation ... Read Answer >>
  5. When is it better to use unlevered beta than levered beta?

    Understand what a security's unlevered beta and levered beta measure, and learn which one is more accurate in measuring a ... Read Answer >>
  6. What does a high unlevered free cash flow indicate about a business?

    Learn the difference between levered free cash flow and unlevered free cash flow. Understand what a high unlevered free cash ... Read Answer >>
Hot Definitions
  1. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  2. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  3. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  4. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  5. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center