How to calculate unlevered cost of equity

Written by bradley james bryant
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How to calculate unlevered cost of equity
Tracking the cost of equity (stock market analysis screenshot image by .shock from Fotolia.com)

Unlevered (unleveraged) equity refers the stock of a company that is financing operations with all equity and no debt. In this case, the cost of capital is only the cost of equity, as there is no debt to account for. Since debt is more costly for companies to issue than equity, the difference between the cost of capital for a company with unlevered equity and a company with levered equity can be significant. This creates economic advantages for companies that raise capital without tapping into the debt markets.

Skill level:
Easy

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Instructions

  1. 1

    Determine the risk-free rate.This is usually the interest rate on 10-year Treasury bonds. You can look this rate up online or in the investment section of a newspaper.

  2. 2

    Determine the expected market return. The expected rate of return is the average market return. In general, investors use 10 per cent as an average stock market return over 10 years.

  3. 3

    Determine the cost of equity. The formula for the cost of equity with no debt is: rf + bu (rm - rf), where rf is the risk-free rate, bu is the delevered beta, and rm is the expected market return. Beta is a measure of risk used by the investor community. A beta over 1 is riskier than the market, a beta of 1 is market-neutral, and a beta less than 1 means the stock is less risky than the average market.

  4. 4

    Determine unlevered beta. The formula for unlevered beta is b(unlevered) / [1+(1-Tc) x (D/E) ], where b is the firm's beta with leverage, Tc is the corporate tax rate, and D/E is the company's debt-to-equity ratio.

  5. 5

    Determine beta. The Wall Street Journal usually lists the beta for a stock. Alternatively, you can ask your broker or look up the metric on an investment research website. A beta of 1 is neutral. A beta over 1 poses more risk, and a beta less than 1 poses less risk.

  6. 6

    Request the annual report from the company's investor relations department or download one from the website if available. If not, ask your broker or download it from an investment research site. The corporate tax rate will be in the notes to the financial statement under Taxes. Use the effective tax rate.

  7. 7

    Look up the debt-to-equity ratio. You can also find this on investment research sites or calculate by dividing total debt by total stockholder equity. Both of these line items can be found on the balance sheet.

  8. 8

    Calculate delevered beta first, then substitute into the cost-of-equity equation for the unlevered cost of equity.

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