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What Is Unlevered Cost of Capital?

Esther Ejim
Esther Ejim

Unlevered cost of capital is a term that is used in reference to a system for the analysis of the cost of a proposed or potential capital project that a company or organization is contemplating. The distinguishing factor between this type of cost estimation and the levered method of estimating costs is the fact that this method simulates an environment where the organization will carry out whatever project it is contemplating on a clean slate, without any need for it to borrow money or compute the costs that will naturally accrue form the acquisition of such financing. This method of cost estimation for projects has a value in that it helps the organization contemplating the project in question to put details in a clearer perspective and separate the true cost of the project from the extra costs that will accrue from obtaining and servicing the debt.

An illustration of the application of an unlevered cost of capital can be seen in the case of a company that is contemplating building a new factory to complement the one it already has. Through the application of the principle of unlevered cost of capital, such a company will be able to differentiate between the real cost of the proposed factory and other extraneous factors. This is due to the fact that under the unlevered cost of capital, the company will only calculate the exact amount the project will require, including the cost for the acquisition of land, the cost for buying the building materials, the costs for construction, and the costs for purchasing the various equipment and machinery that will be put into the factory. In this case, it is clear to see that only the exact money that will be applied to the project will be included in the calculation of costs.

Man climbing a rope
Man climbing a rope

On the other hand, where the company does not apply an unlevered cost of capital and decides instead to apply the opposite, which is the levered cost of capital, it will include other factors into the computation of the cost for the project. As such, the company will include the cost attached to obtaining financing for the project, including the payment of interest for the loan and the payment of dividends to shareholders. Other costs will also include any type of brokerage fees that may be applied to the financing.

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