Unlevered Cost of Capital

Unlevered Cost of Capital (UCC) is a hypothetical rate of return determined on the company's assets on the presumption that there is no leverage. In the absence of leverage, investors estimate returns on equity using the UCC.

UCC is a rate the company would incur if they were to invest in a capital project without using any leverage.

Investments and capital projects with this rate are more affordable than activities and projects with a levered cost of capital.

Using the unlevered cost (UC), potential investors assess the attractiveness of a project or an investment opportunity and the estimated equity returns they would earn when they acquire a stake in the business.

People may become less interested in investing in a project or a company that has had poor unlevered returns (UR) and might not decide to engage in,

Leveraged cost projects and investments have heftier costs than UC projects and investments, which are presumed debt-free due to the debt issue. Therefore, a business's cost to finance a project without accruing debt is known as the UC.

As a result, Investors may choose not to invest in a company if it cannot generate the expected returns.

If all other conditions remain unchanged, an investor may view a company as high risk if it has a higher unlevered capital. This is true even if the investor assumes all other things to be the same.

Formula and Components of Unlevered Cost of Capital

Three elements are crucial when determining the UCC: risk-free rate of return, unlevered beta (UB), and market risk premium.

The risk-free rate is typically the yield on a US 10-year treasury bond, and they are called risk-free rates because there is virtually no chance of the US government defaulting.

UB measures an investment's volatility with the market or other businesses. The market risk premium is determined by subtraction from the risk-free rate of return of the anticipated market returns.

The formula for UCC:

Risk - Free Rate + (Unlevered beta x Market Risk Premium)

Plug in the values to solve the formula, and as a first step, you have to finish the formula's multiplication step before adding the result to the risk-free rate value. Therefore, it's critical to understand each component of the UCC calculation to use it properly.

1. Risk-Free Rate 

The lowest rate of return a business may get without taking any financial risks is known as the "Risk-Free Rate" of return. It is an illustration of the interest that an investor would earn on a risk-free investment.

2. Unlevered Beta 

Also known as asset beta, this UCC component quantifies a company's market risk without taking any debt.

To calculate, you would have to build a comps table with levered betas and unlevering it to remove the impact of capital structures and average the betas to re-lever them to a target capital structure.

3. Expected market returns

These are the returns a company expects from its stock holdings and are a component of the capital asset pricing model (CAPM).

4. Market Risk Premium

The market risk premium is the excess return that the investor would require to invest in a business or stock instead of the government's risk-free securities.

Example

Let's compute the cost using an example to grasp the idea further. Sydney Ltd. is interested in learning the shop's UC. To do so, she engages an investment banker, who reviews the business's financial records to ascertain components of the formula, i.e., market risk premium, unlevered beta, and the risk-free rate.

The screening options for investment bankers are shown below:

With the above information, you can calculate the UCC. You can start by computing the multiplication part of the formula:

= 0.50 + (0.7 * 0.12) = 0.50 + 0.08 = 0.58

This formula postulates that a company will have a higher UCC if investors see the stock carrying a higher risk level.

However, depending on the state of the external market, the precise size may change. Calculating the UCC assumes that the business does not commit, regardless of whether it has one.

An investor downturn or rejection of investments may occur for a company with poor UR. However, projects with non-leveraged costs are presumed to be debt-free. On the other hand, leveraged cost projects and acquisitions create more significant expenses due to issuing debt.

The UC of the enterprise is the price of minimally financing an undertaking without accumulating any commitment. Therefore, even if the firm has a duty, it is essential to ignore the obligation component and its cost when calculating the UCCl.

It might not be a sensible investment if the estimate yields an unleveraged capital cost of 10% and the company's return falls below that mark. The real returns may be estimated by evaluating the results against the present cost of debt held by the organization.

For example, if a company's cost of debt is 7%, and the UCC is 16%, its Weighted Average Cost of Capital (WACC) will be lower than 16%.

This UC is still instructive, but investor money may transfer to alternative investments if the company cannot deliver the 10% UR that investors in this market are expecting.

Usage of Unlevered Cost of Capital when the Company Has Debt

Even if the company had debt, it would be necessary to subtract the debt component from the total to determine the unlevered component.

The non-leveraged WACC considers an ideal scenario with no debt. The tax component of a typical WACC affects the cost of debt. As a result of our assertion, there is no debt, the weight of debt is zero, and taxes have no bearing.

The Capital Asset Pricing Model (CAPM ) can be used to calculate the non-leveraged WACC or Cost of Equity. The only issue is that leverage affects beta. Therefore, we must unlever the beta to calculate non-leveraged WACC.

This UC is still valuable, but if the company cannot meet market expectations of annual UR, investor funds may be transferred to other opportunities. The price of the company's shares will decrease as a result.

Unlevered vs. Levered Cost of Equity

Since a non-leveraged company has no debt that it could default on, it does not pose a default risk to investors. Therefore, the risk of investing in a non-leveraged corporation is smaller. For its investments and operations, a levered corporation uses debt finance.

Leveraged businesses provide a greater risk to investors since there is a chance that they may be unable to pay their debts on time and will ultimately have to seek bankruptcy protection.

A non-leveraged company has no debt and is entirely funded by equity. In a non-leveraged firm, the value of the equity is the same as the firm's worth.

Therefore, the above formula will help you determine a non-leveraged corporation's value.

The cost of equity is another name for the required rate of return. Companies frequently utilize the dividend capitalization model or the capital asset pricing model to calculate their required rate of return.

Investors are thought to be prepared to accept a minimal return, which is the required rate of return.

Leveraged companies may appear to be the safer investment option, but non-leveraged companies carry less risk. Nevertheless, having debt is not always a terrible thing.

Companies that borrow funds can put those funds to use in other ventures with a high potential return for shareholders, boosting shareholder wealth.

Finding the correct ratio of debt to equity to enable a business to grow while retaining a manageable level of investment risk is the key to balancing risk and growth.

Why is the Unlevered Cost of Capital Important?

In the valuation process, the role of WACC is crucial as it is required to discount the cash flows, and UCC forms a part of the WACC calculation.

When determining how much to value a share on the stock market, the cost of equity is crucial. Like all other investment classes, equity expects to pay its investors a return. The issue is, unlike debt and other classes, the cost of equity is never genuinely clear-cut.

The cost of debt for your business can be quickly determined by looking at the interest rates you are paying. But the price of equity is indicated. Equity holders take what's left over from the earnings, called the residual value. Therefore, it is not directly accessible.

However, the cost of equity is necessary for valuation purposes. Thus, you will choose a lower discount rate without the equity cost, which would likely result in selecting the wrong investments.

The WACC is the average return on investments a business needs to achieve to appease its creditors and stockholders. Each component's weight has been assigned per the proportionate importance of each group.

A greater weight will be given to the equity component in the calculation, for instance, if equity investors are more significant than debt holders.

The WACC is employed to determine whether the investment initiatives of a firm are yielding sufficient returns. If a project's return is less than the WACC, it should be rejected; if it exceeds the WACC, it should be approved.

Financial analysts should be aware of the UCC because it is a crucial component in the WACC computation.

Advantages and Disadvantages of using Unlevered Cost of Capital

Using any cost of capital or discount rates has its advantages and disadvantages. The following points shed light on them:

Advantages:

1. The UCC's primary benefit is it gives a precise picture of an investment's prospective profitability. Businesses can compare returns on various investments more fairly by removing the impact of leverage.
2. The UCC can help assess projects with various risk levels. It can assist firms in identifying these initiatives because riskier investments typically demand a higher return.
3. It will help an organization find an optimum capital structure. Asset beta or UB is required as a part of the UCC calculation, which usually involves non-leveraged public companies' levered beta and then re-levering back to the optimal capital structure.

Disadvantages:

1. Utilizing the UCC has several disadvantages. It's assumed that companies can source unlimited capital at zero cost. In practice, this is frequently untrue, and companies may need help to raise the money they require for their investment.
2. Furthermore, since it does not account for the time value of money, it could overestimate the actual cost of an investment. It is not a valuable instrument for corporations evaluating new investments.
3. It is just a hypothetical evaluation to determine the rate of return if the company is fully funded through equity. Realistically speaking, this might not happen, and almost every company trade nowadays uses leverage, and using UCC might not reflect the true picture/riskiness of the investment.

Mistakes when using Unlevered Cost of Capital

One of the most frequent errors when employing UCC is failing to account for the particular financing mix of the organization. This error may cause one to overestimate or underestimate the actual Cost of Capital, which may result in poor decision-making.

Making use of an incorrect discount rate is another frequent mistake. This frequently occurs when businesses choose a discount rate that is either too high or too low because they fail to consider the time value of money.

Finally, some businesses mistakenly assume that it is a constant. In truth, it may alter over time depending on the state of the economy, the company's finances, and other variables.

Therefore, it's crucial to evaluate and revise predictions of the UCC frequently. Businesses can more precisely determine the actual cost of capital and make better investments and other strategic decisions by avoiding these mistakes.

Also, using the levered beta instead of non-leveraged could be another mistake many analysts make. However, to calculate UCC, UB is necessary and can be easily computed.

First, you need a list of comparable companies that fit the company you'd like to evaluate and ascertain their levered betas.

Second, levered beta needs to be unlevered by using the following formula:

Levered Beta/ 1+ ((1 - T) * (D/ E))

Effectively, this will remove the impact of financing or capital structure and provide you with the asset beta of companies, which can be easily compared to other companies and used in the formula.

Approach to Avoid Mistakes when Employing Unlevered Cost of Capital

It is a popular method used by businesses to calculate the rate of return on investments. However, there are a few possible hazards with the use of UCC. One is that the risk involved with leveraged investment vehicles is not considered.

Omission of leverage while calculating the cost of capital could be a disaster as it would throw off the valuations of the businesses. Factoring leverage would enable investors to calculate the actual cost of capital that represents the business.

This can cause you to overestimate the possible ROI. Additionally, because the UCC does not consider the time value of money, it could overestimate the actual Cost of Capital.

Therefore, investors should be cautious of using UCC to evaluate an opportunity or to make investment decisions, and enterprises should be mindful of these restrictions. Businesses can steer clear of costly errors by considering these variables.

Measuring the Success of the Business with No Debt

Businesses succeed by generating revenue; the more revenue a business can generate from its assets, the more successful it will be.

Most firms incur debt to obtain the necessary financing. As a result, returns on equity and assets differ significantly. However, figuring out the return on assets for non-leveraged businesses is more straightforward.

Return on Assets

The return on asset formula is straightforward at its core. First, divide a company's net income by its assets. Then, the company's return on the support shown on its balance sheet is calculated as a percentage.

Some investors prefer to factor in how much a company spends on interest costs when evaluating debt-ridden companies.

The interest expense is subtracted from the net income statement; therefore, bringing it back in might help you understand the return on assets that use the leverage from borrowed money.

A non-leveraged business, on the other hand, won't incur any interest costs because it won't be financing any debt. A corporation without debt will have minimal liabilities (if any) because debt is often the largest liability on a company's balance sheet.

Finally, because there won't be much spread between total assets and shareholders' equity, its return on assets will be comparable to its return on equity.

Usage of Return on Assets for a non-leveraged Firm

Looking at returns on assets can be worthwhile for a non-leveraged company thinking about taking on debt for the first time.

The typical reason for debt financing is that a firm thinks it can achieve a higher return on investment than the cost of capital, and by taking on debt, the company would ultimately generate a higher return on equity.

But remember that even a successful business with debt funding can potentially lower asset returns.

If the marginal return on the enterprise financed with debt is lower than the return on the unexpanded business, that will happen.

A reason for this is even though an expansion plan can increase earnings, investors may be wary of it if the predicted rate of return is lower than the company has typically generated.

The easiest company to examine is not leveraged because knowing a company's return on assets reveals its current profitability and provides a benchmark for its future success.

You may learn a lot more about how the businesses you invest in create money for you if you take the time to look at returns on assets.

Researched & Authored by Frank Pereira | LinkedIn