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An unlevered firm is a company with no debt, and is referred to as unlevered because it doesn't have financial leverage. Financial leverage is created when a company utilizes borrowing, usually from lenders, or from investors, by issuing debt through bonds or preferred stock..
Unlevered versus Levered
An unlevered company does not present a default risk to investors because it does not have debt on which it can default. An unlevered company presents a lower investment risk. A levered company utilizes debt financing for its investments and operations. For investors, the investment risk increases in levered companies because the possibility exists that the firm may fail to meet its debt obligations and end up filing for bankruptcy protection.
Value of Equity
An unlevered firm carries no debt and is financed completely through equity. The value of equity in an unlevered firm is equal to the value of the firm. The equation to calculate the value of an unlevered firm is: [(pre-tax earnings)(1-corporate tax rate)] / the required rate of return. The required rate of return is also referred to as the cost of equity. Firms often use the capital asset pricing model or the dividend capitalization model to determine its required rate of return. The required rate of return is considered the minimum return investors are willing to accept.
Value of Equity Example
Assume a firm has pretax earnings of $100, its corporate tax rate is 35 percent and its required rate of return is 10 percent. Plugging these numbers into the value of equity equation, you get: [($100)(1 - 35 percent)] / 10 percent. To solve for this problem, you must solve for the number inside of the parenthesis first. This translates into ($100) (1 - .35 = .65) / .08. Now, solve for the right side of the equation: $100 x .65 = $65. Now solve for the equation: $65 / .10 = $650. The value of equity in this unlevered firm is $650.
On the surface, unlevered firms may seem like the better investment choice over levered firms because they carry less investment risk. However, carrying debt is not necessarily a bad thing. Companies that borrow money can use that money for other investments that can potentially earn high returns for shareholders, increasing shareholder wealth. The key between risk and growth for a company using financial leverage is to find the right mix of debt and equity to both help grow the firm while maintaining an acceptable level of investment risk.