Unlevered Cost Of Capital
Unlevered cost of capital is an analysis using either a hypothetical or an actual debt-free scenario to measure a company's cost to implement a particular capital project (and in some cases used to assess an entire company). Unlevered cost of capital compares the cost of capital of the project using zero debt as an alternative to a levered cost of capital investment, which means using debt as a portion of the total capital required.
Unlevered Cost of Capital
Definition
The unlevered cost of capital is an analytical method that measures the cost of implementing a specific capital project for a company under the assumption or actual condition of having no debt. It is often used to evaluate the capital cost of an entire company or a specific project. The unlevered cost of capital compares the capital cost of a project using zero debt as an alternative to the leveraged capital investment that includes debt as part of the total required capital.
Origin
The concept of unlevered cost of capital originates from modern capital structure theory, particularly the Modigliani-Miller theorem. This theorem posits that in an ideal market without taxes, bankruptcy costs, and information asymmetry, a company's capital structure does not affect its total value. This theory provides the foundation for the analysis of unlevered cost of capital.
Categories and Characteristics
The unlevered cost of capital can be divided into two main categories: hypothetical unlevered cost of capital and actual unlevered cost of capital. Hypothetical unlevered cost of capital assumes the company has no debt, while actual unlevered cost of capital refers to the capital cost of a company that operates without any debt in practice.
Characteristics include: 1. No debt: Assumes the company has no debt. 2. Capital cost: Considers only the cost of equity capital. 3. Comparative analysis: Compares with leveraged capital cost to assess the impact of debt on capital cost.
Specific Cases
Case 1: Suppose Company A plans to invest in a new project with a total capital requirement of $10 million. If Company A uses entirely equity financing (unlevered), its capital cost is 10%. If Company A uses 50% debt financing with a debt interest rate of 5%, its weighted average cost of capital (WACC) might reduce to 8%. By comparing unlevered and leveraged capital costs, Company A can assess the benefits of debt financing.
Case 2: Company B, when evaluating its overall capital structure, finds that its current leveraged capital cost is 7%. By calculating the unlevered cost of capital, Company B discovers that if it uses entirely equity financing, its capital cost would rise to 9%. This indicates that moderate debt financing can lower the company's overall capital cost.
Common Questions
1. Why calculate the unlevered cost of capital?
Calculating the unlevered cost of capital helps companies assess the impact of debt financing on capital cost, thereby optimizing their capital structure.
2. What is the difference between unlevered cost of capital and weighted average cost of capital (WACC)?
The unlevered cost of capital considers only the cost of equity capital, while WACC takes into account both equity and debt costs.
