Unlevered Cost of Capital

Unlevered Cost of Capital

Definition

The unlevered cost of capital is the required rate of return for a project or firm assuming no debt (a debt-free or “unlevered” capital structure). It reflects the return investors would demand if the business were financed solely with equity, isolating business risk from the effects of leverage.

Why it matters

• Provides a benchmark for evaluating projects independent of financing decisions.
• Shows the implied rate of return on assets before debt tax shields and interest effects.
• Helps compare investments and assess whether taking on debt (leverage) would lower a firm’s overall cost of capital.
• A higher unlevered cost of capital generally signals greater underlying business risk.

Key components

• Risk-free rate: The return on a default-free asset (commonly government bonds).
• Unlevered beta (asset beta): Measures the asset’s volatility relative to the market, excluding financial leverage. It can be estimated by unlevering comparable companies’ levered betas or by averaging peers’ asset betas.
• Market risk premium: The expected excess return of the market over the risk-free rate.

Formula and calculation

Unlevered Cost of Capital = Risk-Free Rate + Unlevered Beta × Market Risk Premium

Steps:
1. Identify a suitable risk-free rate.
2. Estimate the unlevered beta (from peer comparables or by unlevering observed levered betas).
3. Determine the market risk premium.
4. Plug values into the formula to compute the unlevered cost of capital.

Interpretation and use

• Lower unlevered cost of capital indicates lower business risk and makes projects more attractive on a risk-adjusted basis.
• If a project’s expected return is below the unlevered cost of capital, the project may not justify the required return given its business risk.
• Comparing the unlevered cost to the firm’s cost of debt can reveal whether adding leverage is likely to reduce overall capital costs (as reflected in WACC).

Relation to levered measures

• Levered cost of capital accounts for the firm’s actual capital structure (debt plus equity). Because debt often carries a lower pre-tax cost than equity and interest has tax advantages, levered cost of capital (or WACC) is typically lower than the unlevered cost of capital.
• Use the unlevered measure to evaluate projects on a pure asset-risk basis, and WACC to evaluate them given the firm’s chosen financing mix.

Conclusion

The unlevered cost of capital isolates business risk by showing the required return in a debt-free scenario. It’s a useful benchmark for project appraisal, peer comparisons, and assessing whether leverage will plausibly reduce a firm’s overall cost of capital.