Unlevered Cost of Capital – Definition

Cite this article as:"Unlevered Cost of Capital – Definition," in The Business Professor, updated September 20, 2019, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/unlevered-cost-of-capital-definition/.

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Unlevered Cost of Capital Definition

The unlevered cost of capital is the evaluating of the expected rate of return on a company’s assets using a hypothetical debt-free situation. The unlevered cost of capital is purely theoretical, it is an evaluation of a company that maintains that the company can finance itself without any debt. Also, the cost of executing a capital project by a company is estimated without the effect of debt.

When investors use the unlevered cost of capital, it is an estimate of equity returns without any debt.

A Little More on What is Unlevered Cost of Capital

Typically, capital projects and investments in an unlevered cost of capital are cost-effective, they are not expensive as the levered cost of capital. Using the unlevered cost of capital, investors measure the strength of the investment of a company and equity returns they are likely to get when they invest in the company. A company with low unlevered returns can experience a downturn of investors or rejection of investments by investors.

Higher costs are generated in levered cost projects and investments due to issuance of debt, unlevered cost projects however are presumed to be debt-free. The cost of a compact financing a project without accumulating any debt is the unlevered cost of project.

Unlevered Cost of Capital Calculation

When calculating the unlevered cost of capital, certain factors are essential, these are; market risk premium, Unlevered Beta and risk-free rate of return.

The Formula for calculating unlevered cost of capital is:

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

Unlevered Beta means the volatility of an investment when compared to the market or other companies. Market Risk Premium on the other hand, is calculated by deducting the expected market returns from the risk-free rate of return.

References for “Unlevered Cost of Capital

https://www.investopedia.com › Business › Business Essentials

https://financial-dictionary.thefreedictionary.com/Unlevered+cost+of+equity

https://corporatefinanceinstitute.com › Resources › Knowledge › Valuation

Academic research for ““Unlevered Cost of Capital

Discounting Tax Shields and the Unlevered Cost of Capital, DeMarzo, P. M. (2005). Discounting Tax Shields and the Unlevered Cost of Capital. Available at SSRN 1488437.

The weighted average cost of capital, perfect capital markets, and project life: a clarification, Miles, J. A., & Ezzell, J. R. (1980). The weighted average cost of capital, perfect capital markets, and project life: a clarification. Journal of financial and quantitative analysis, 15(3), 719-730.

Corporate valuation: the combined impact of growth and the tax shield of debt on the cost of capital and systematic risk, Ehrhardt, M. C., & Daves, P. R. (2002). Corporate valuation: the combined impact of growth and the tax shield of debt on the cost of capital and systematic risk. Journal of Applied Finance, 12(2), 31-38.

An APV analysis of capital budgeting under inflation, Ezzell, J. R., & Kelly Jr, W. A. (1984). An APV analysis of capital budgeting under inflation. Financial Management, 49-54.

Valuation and cost of capital formulae with corporate and personal taxes: a synthesis using the Dempsey discounted dividends model, Dempsey, M. (2001). Valuation and cost of capital formulae with corporate and personal taxes: a synthesis using the Dempsey discounted dividends model. Journal of Business Finance & Accounting, 28(3‐4), 357-378.

The discount rate for discounted cash flow valuations of intangible assets, Schauten, M., Stegink, R., & de Graaff, G. (2010). The discount rate for discounted cash flow valuations of intangible assets. Managerial Finance, 36(9), 799-811.

Valuation, Tax Shields and the Cost-of-Capital with Personal Taxes: A Framework for Incorporating Taxes, Schultze, W. (2004). Valuation, Tax Shields and the Cost-of-Capital with Personal Taxes: A Framework for Incorporating Taxes. International Journal of Theoretical and Applied Finance, 7(06), 769-804.

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