Unlike advertising or other costs, a company’s unlevered cost of equity doesn’t require any actual cash payments. This cost represents the annual percentage return investors would require to own the company’s stock if the company had no debt, or leverage. Analysts use the unlevered cost of equity to estimate a company’s value, but the figure also provides insight into the market’s opinion of a stock’s risk. In general, companies with a higher unlevered cost of equity are considered riskier than other firms because investors want more potential reward for more risk.
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Calculating the unlevered cost of equity requires a specific formula, which is B/[1 + (1 - T)(D/E)], where B represents beta, T represents the tax rate as a decimal, D represents total liabilities, and E represents the market capitalization.
Determine the Company's Liabilities
To calculate the unlevered cost of equity, first download a company’s Form 10-K annual report from the investor relations section of its website or from the U.S. Securities and Exchange Commission’s online EDGAR database. Find the company's corporate tax rate in the annual report. Find the amount of total liabilities on its balance sheet.
Look up the market capitalization and beta of the company’s stock on the stock’s quote page on any financial website. Also, find the yield on 10-year Treasury notes in the bonds or interest rates section of the website.
Calculate the Unlevered Beta
Substitute the figures into the formula B/[1 + (1 - T)(D/E)], in which B represents beta, T represents the tax rate as a decimal, D represents total liabilities, and E represents the market capitalization. For example, assume a company has a 35 percent tax rate, $1 billion in total liabilities, a $4 billion market capitalization and a beta of 0.9. The formula is 0.9/[1 + (1 - 0.35)($1 billion/$4 billion)].
Calculate the formula to determine the unlevered beta. In this example, divide $1 billion by $4 billion to get 0.25. Subtract 0.35 from 1 to get 0.65. Multiply 0.25 by 0.65 and add 1 to get 1.1625. Divide 0.9 by 1.1625 to get an unlevered beta of 0.77.
Determine the Unlevered Cost of Equity
Estimate the excess annual percentage return you believe investors currently require to own stocks instead of risk-free Treasury securities. You can use a higher estimate if you believe stocks are currently more risky than normal, or a lower one if stocks are less risky. In this example, assume a 5.4 percent premium is acceptable for the current market. Multiply your estimated risk premium by the unlevered beta. In this example, multiply 5.4 percent by 0.77 to get 4.16 percent.
Add your result to the yield on 10-year Treasury notes to calculate the unlevered cost of equity. Concluding the example, assume 10-year Treasury notes have a 5 percent yield. Add 4.16 percent to 5 percent to get a 9.16 percent unlevered cost of equity. Investors would require a 9.16 percent return from the stock if the company had no debt. The market perceives this stock to be less risky than one with, say, a 15 percent unlevered cost of equity.
The unlevered cost of equity alone is insufficient to fully understand a stock’s risk and doesn’t guarantee any specific returns. Always review a company’s financial and other information when considering an investment.
- The unlevered cost of equity alone is insufficient to fully understand a stock’s risk and doesn’t guarantee any specific returns. Always review a company’s financial and other information when considering an investment.