Key Takeaways
- Cost of capital assuming no debt financing.
- Isolates business risk from financial risk.
- Calculated using risk-free rate and unlevered beta.
- Useful for comparing companies with different capital structures.
What is Unlevered Cost of Capital?
The unlevered cost of capital is the expected rate of return on a company’s assets assuming it is financed entirely by equity, with no debt in its capital structure. This metric isolates the business risk from financial risk, providing a clearer view of the asset’s inherent cost.
Unlike the weighted average cost of capital (WACC), which accounts for both debt and equity financing, the unlevered cost of capital assumes a 100% equity-financed scenario, making it useful for comparing companies with different leverage levels.
Key Characteristics
Understanding the unlevered cost of capital involves several core elements:
- Business Risk Focus: It reflects the risk of the company’s operations alone, excluding financial leverage effects.
- Unlevered Beta: Uses unlevered beta to measure market risk, removing the influence of debt on volatility.
- Risk-Free Rate: Incorporates the baseline return from riskless investments, typically government bonds.
- Market Risk Premium: Adds the expected premium investors require over the risk-free rate for market exposure.
- Benchmarking Tool: Helps compare companies or projects independently of capital structure differences.
How It Works
The unlevered cost of capital is calculated using the Capital Asset Pricing Model (CAPM) framework, adjusting beta to remove the effect of leverage. This results in a rate that reflects only the asset’s operational risk, not the risks from debt financing.
By isolating business risk, you can analyze investment opportunities or companies like Bank of America and JPMorgan Chase on a comparable basis regardless of their differing debt levels, improving decision-making clarity.
Examples and Use Cases
Unlevered cost of capital is widely applied in financial analysis and valuation:
- Banking Sector: Comparing unlevered cost of capital for firms like Citigroup and Visa helps isolate their core business risks despite varied capital structures.
- Project Evaluation: Companies use this metric to assess new investments without the distortion of financing decisions.
- Valuation Models: Used in discounted cash flow (DCF) models to value firms on an unlevered basis before factoring in leverage.
Important Considerations
While the unlevered cost of capital offers valuable insight into business risk, you should remember it assumes no debt, which may not reflect actual company financing. Adjusting for tax effects and capital structure is crucial when moving from unlevered to levered valuations.
Also, estimating unlevered beta requires accurate data on a company's leverage and tax rates. For practical application, understanding the relationship between unlevered cost of capital and WACC is essential to align financial strategy with investor expectations.
Final Words
The unlevered cost of capital isolates business risk by assuming no debt, providing a clear benchmark for asset returns. To apply this metric effectively, calculate it for your company or project to compare performance independent of financing choices.
Frequently Asked Questions
Unlevered Cost of Capital is the expected rate of return a company anticipates earning on its assets assuming it is financed entirely with equity and has no debt. It isolates the business risk from financial risk created by leverage.
Unlike WACC, which reflects a company's actual mix of debt and equity financing, the Unlevered Cost of Capital assumes the company is 100% equity financed. This makes it useful for comparing companies or projects without considering their capital structure.
The Unlevered Cost of Capital is calculated using the formula: Risk-Free Rate plus Unlevered Beta multiplied by the Market Risk Premium. This follows the Capital Asset Pricing Model (CAPM) framework.
You need the Risk-Free Rate, Unlevered Beta, and Market Risk Premium. The risk-free rate is usually from government bonds, unlevered beta measures business risk excluding financial leverage, and the market risk premium reflects the extra return expected from investing in the market.
You can calculate Unlevered Beta by dividing the Levered Beta by one plus the product of (1 minus tax rate) and the debt-to-equity ratio. This removes the financial risk component and isolates business risk.
It serves as a benchmark to evaluate investment decisions by showing the pure business risk return expectation without the effects of debt. If a company’s unlevered cost is higher than its actual cost of capital, it may indicate potential value from leverage.
Yes, because it assumes no debt, it provides a standardized way to compare companies with different capital structures by focusing solely on the business risk of their assets.
