How to Calculate Unlevered Cost of Equity

How to Calculate Unlevered Cost of Equity
Tracking the cost of equity

Step 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.

Step 2

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

Step 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.

Step 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.

Step 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.

Step 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.

Step 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.

Step 8

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