Distinguish the unlevered cost of capital from the WACC.

Question

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The Answer is For an all-equity-financed,or 'unlevered',firm,the appropriate risk-adjusted discount rate for a project's future cash flow when the cash flow has the same risk as the overall firm is the firm's cost of capital.The unlevered cost of capital is the expected return on the equity of the firm if the firm is financed entirely with equity.Because there is no debt tax shield for a firm that is financed entirely with equity,and because the two sides of the balance sheet 'balance',the unlevered cost of capital is also the required rate of return on the firm's unlevered assets.The weighted average cost of capital or WACC is a weighted average of the after-tax expected return paid by the firm on its debt and equity.In the absence of a debt tax shield,debt subsidy or other market frictions that favour one form of financing over another,the WACC is the expected return of the firm's assets.In this case,the WACC and the unlevered cost of capital are the same.The expected return paid by the firm to its equity holders is the same as the expected return received by the equity holders.When a third party,such as the government taxing authority,favours one form of financing over another,the cost of the favoured form of financing will differ from the expected return to investors.For example,the tax deductibility of interest implies that the cost of debt financing to a corporation (as measured by the after-tax return paid by the corporation)may be less than the rate of return on a firm's debt received by the firm's debt holders.Because of this,the WACC differs from the unlevered cost of capital when there is a debt tax shield.

Distinguish the Unlevered Cost of Capital from the WACC