when a company needs to raise capital for expansion or other reasons it has two options 1 debt financing which is to borrow money through loans or bond issuances or 2 equity financing which is the issuance of stock 1
the unlevered cost of capital is generally higher than the levered cost of capital because the cost of debt is lower than the cost of equity borrowing money is cheaper than selling equity in the company this is true given the tax benefit related to the interest expense paid on the debt there are costs associated with levered projects including underwriting costs brokerage fees and coupon payments however nevertheless over the life of the capital project or the firm s ongoing business operations these costs are marginal compared to the benefits from the lower cost of debt compared to the cost of equity the unlevered cost of capital can be used to determine the cost of a particular project separating it from procurement costs the unlevered cost of capital represents the cost of a company financing the project itself without incurring debt it provides an implied rate of return which helps investors make informed decisions on whether to invest if a company fails to meet the anticipated unlevered returns investors may reject the investment in general if an investor believes a stock is a high risk it will typically be because it has a higher unlevered cost of capital other aspects being constant the weighted average cost of capital wacc is another formula that investors and companies use to determine whether an investment is worth the cost wacc takes into consideration the entire capital structure of a firm which includes common stock preferred stock bonds and any other long term debt formula and calculation of unlevered cost of capitalseveral factors are necessary to calculate the unlevered cost of capital which includes unlevered beta market risk premium and the risk free rate of return this calculation can be used as a standard for measuring the soundness of the investment the unlevered beta represents an investment s volatility as compared to the market the unlevered beta also known as asset beta is determined by comparing the company to similar companies with known levered betas often by using an average of multiple betas to derive an estimate the calculation of market risk premium is the difference between expected market returns and the risk free rate of return once all variables are known the unlevered cost of capital can be calculated with the formula unlevered cost of capital risk free rate unlevered beta market risk premium if the result of the calculation produces an unlevered cost of capital higher than the company s return then further analysis should be conducted the comparison of the result to the cost of a company s debt can determine the benefits of incurring debt and utilizing leverage to lower the cost of total capital including equity and debt 