What is Unlevered Cost Of Capital?

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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.

Definition

The unlevered cost of capital is an analytical method used to measure the cost for a company to undertake a specific capital project under the assumption or reality of having no debt. This method is sometimes used to evaluate the capital cost of an entire company. The unlevered cost of capital compares the capital cost of a project using zero debt as an alternative with a leveraged capital investment that uses debt as part of the total required capital, helping companies assess the impact of different financing strategies.

Origin

The concept of unlevered cost of capital originated from the development of capital structure theory, particularly in the mid-20th century. As research into the impact of corporate financing decisions deepened, scholars began to focus on how different capital structures affect company value. The unlevered cost of capital became an important tool for evaluating a company's capital cost in a debt-free scenario.

Categories and Features

The unlevered cost of capital is primarily used to assess the capital cost of a project or company without considering the impact of debt financing. Its features include: 1) Providing a pure assessment of capital cost by assuming a debt-free scenario; 2) Helping companies understand cost differences under different capital structures; 3) Typically used in comparison with leveraged cost of capital to evaluate the benefits and risks of debt financing.

Case Studies

Case 1: Suppose a tech company plans to invest in a new project. By calculating the unlevered cost of capital, the company can assess the capital cost of the project without using debt financing. This helps the company decide whether to raise funds through issuing equity or other means. Case 2: A manufacturing firm considering restructuring its capital structure uses the unlevered cost of capital to evaluate the capital cost in a fully equity-financed scenario. This allows the firm to compare the costs and risks of different financing options.

Common Issues

Common issues investors face when applying the unlevered cost of capital include: 1) How to accurately estimate the unlevered cost of capital? This typically requires using market data and financial models. 2) Is the unlevered cost of capital always better than the leveraged cost of capital? This depends on the specific circumstances of the company and market conditions, and cannot be generalized.

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