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.