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What is Asset Cost of Capital?
Asset cost of capital refers to the capital of a firm when the financing of a project is purely done by equity without any form of debt. It is the expected rate of return on the company's assets in a hypothetical debt-free method. Asset cost of capital is also known as the unlevered cost of capital because it is done without any financial leverage of debt. It is completely a financial position where a company can finance without taking care of any debt.
The cost of executing a project in a completely debt-free manner is the asset cost of capital. As mentioned above, in the case of asset cost of capital all fundings of a project is done by internal equity without taking any debt from the market. When investors use the asset cost of capital, it represents an equity return without any debt.
How Does Asset Cost of Capital Work?
Unlevered cost of capital is a measure of the power of a company to invest in a project without having to collect any debt from the market.
Investors check the asset cost of capital while determining the rate of return of a company in an investment project.
Companies with low asset cost of capital are more likely to be faced with a downturn in a business.
Also, the asset cost of capital is a determinant of the financial wellbeing of a company. That is why, companies sometimes reject investing in projects where the companies have a low asset cost of capital.
Notably, higher costs are levied on projects that have debt or in those that have leverage on financing. That is why, having unlevered cost of capital is realized as a sign of the strength of a company to finance its projects in whichever way the company wants.
Calculating Unlevered Cost of Capital
To calculate the asset cost of capital, some factors need to be included. These factors are market risk premium, unlevered beta, and the risk-free rate of return. The formula that is used to calculate unlevered cost of capital is,
$$\mathrm{Unlevered\:Cost\:of\:Capital\:=\:\mbox{Risk-Free}\:Rate\:+\:Unlevered\:Beta\:(Market\:Risk\:Premium)}$$
Unlevered beta means the volatility of an investment when compared to the market rates of other firms. The market rate of return is the result when the expected rate of return is subtracted from the risk-free return.
Conclusion
The asset cost of capital is related to the situation when the investment in a project is made without collecting any debt from the market. However, in most cases, the firms need to collect a debt to finance their project. That is why the term is more hypothetical than real in nature.
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