Unlevered cost of equity
DCFThe return equity holders would require if the business carried no debt, used as the discount rate in an APV analysis.
If a company had no debt, its equity would carry only business risk, and the return shareholders required would be lower than what they demand from the same business levered. That rate is the unlevered cost of equity.
It is calculated from CAPM using the asset beta rather than the levered beta, so the risk being priced is the operations alone.
Its main use is adjusted present value, where the unlevered business is valued first at this rate, and the value of financing effects such as the interest tax shield is added separately afterwards.
It also serves as a sanity anchor. It should always sit above the cost of debt and below the levered cost of equity, and a calculation that violates either bound has an input error rather than an insight.
Worked example
With a 3.0% risk free rate, a 5.5% equity risk premium and an asset beta of 0.98, the unlevered cost of equity is 3.0 plus 0.98 times 5.5, or 8.4%.
The levered cost of equity at a 1.24 beta is 9.8%, and the after tax cost of debt is 3.75%.
The unlevered figure sits between the two, as it must. A calculation putting it outside that range has an input error rather than an insight.