When companies decide to expand, they have several financing options to pursue for expansion funds. If their operations generate significant cash flow, companies can use this operational cash flow to fund expansion. They can issue and sell more shares or they can issue bonds or obtain loans. When a company uses no debt financing, it has unlevered equity.
Equity represents the ownership stake one or more individuals or entities have in a business. For publicly traded corporations, equity is referred to as shareholder's equity. For sole proprietorships or small businesses that operate as an extension of their owners, equity is referred to as owner's equity. On the balance sheet, equity includes the investment from the founders, venture capitalists and initial public offerings plus the profits the business retains or minus any losses. Equity also reflects any owner withdrawals or dividend distributions.
Equity versus Debt
Whereas equity represents an ownership interest in a business, debt can represent the liabilities a business has. On a balance sheet, assets equal liabilities plus equity. Liabilities include the accounts payable that companies owe to suppliers and vendors, income taxes payable and similar monies due businesses and government entities for various purposes. However, when talking about levered or unlevered equity, debt refers only to those liabilities which arise from written financing agreements with lenders and creditors. Therefore, debt includes mortgages, term loans, lines of credit and bonds.
Unlevered Equity - Example
Leverage refers to the amount of debt a company has. For example, a company may buy a property for $3 million. It obtains a mortgage for 70 percent of its purchase price or $2.4 million. It uses its own cash to pay the remaining $600,000. The company therefore leveraged its $600,000 in equity with $2.4 million in debt. Unlevered equity is the lack of debt. If the company paid $3 million of its own cash for the property, the building is unlevered and the company has unlevered equity in it.
Equity in a company that has no debt is called unlevered equity. Put another way, when a company uses 100 percent equity financing, it has unlevered equity. When a company has unlevered equity, it has no financial risk. Leverage increases the financial risks of equity. However, leverage has an upside. It increases the returns that go to equity holders. The expected returns on levered equity are higher than that for unlevered equity.
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