In project finance, the concept of levered vs. unlevered return refers to the difference in returns when a project is financed with debt (levered) versus when it is financed solely with equity (unlevered).

The levered return is the return on equity for a project when it is financed with both debt and equity. This return takes into account the cost of the debt financing used in the project. In contrast, the unlevered return is the return on equity for a project when it is financed solely with equity. This return does not take into account any debt financing costs.

The key return metrics used in project finance and for the distinction between levered vs. unlevered return are the Internal Rate of Return (IRR), Cash on Cash (CoC), Payback Period, and Net Present Value (NPV).

IRR is the discount rate at which the present value of cash inflows equals the present value of cash outflows. It represents the expected annualized rate of return for an investment. The IRR of a leveraged project will be higher than the IRR of an unleveraged project if the cost of debt is lower than the cost of equity. The IRR is a key financial metric when it comes to distinguishing levered vs. unlevered return.

CoC is the ratio of the annual cash flow received from the project to the amount of initial investment. It represents the cash return received for each Euro invested. In a levered context, CoC is affected by debt service payments. As debt service payments increase, the amount of cash available for equity investors decreases, resulting in a lower CoC during the debt repayment period. Conversely, when debt service payments decrease or are eliminated, the amount of cash available for equity investors increases, resulting in a higher CoC.

The payback Period is the time required for a project to generate enough cash inflows to recover the initial investment. It represents the amount of time it takes to recoup the initial investment. Leverage can also impact the payback period of a project. In general, when debt is added to the capital structure, the total amount of cash flow required to repay the debt increases, which extends the payback period. Conversely, when debt is reduced or eliminated, the total amount of cash flow required to repay the debt decreases, which shortens the payback period. However, this is only a rule of thumb and may not be the case for a specific project. For an exact comparison, it is recommended to build a project finance model which can compare levered vs. unlevered return metrics directly.

NPV is the difference between the present value of cash inflows and the present value of cash outflows. It represents the net gain or loss from an investment. The NPV of a leveraged project will be higher than the NPV of an unleveraged project if the cost of debt is lower than the cost of equity. This is because the use of debt financing reduces the amount of equity required to fund the project, which increases the cash flows available to equity investors and leads to higher overall returns.

In summary, the use of leverage can indeed enhance the IRR and NPV of a project if the cost of debt is lower than the cost of equity. However, it is important to note that leverage also increases the risk of the project, as higher levels of debt increase the likelihood of default or bankruptcy. Therefore, it is crucial for investors to carefully evaluate the potential risks and returns of a leveraged project before making any investment decisions.

Unlevered return metrics are essential to comparing "apples to apples" because they allow for a direct comparison of the returns on projects that are financed with different levels of debt – by stripping out the effect of leverage in the calculation process of these return metrics. By using unlevered return metrics, investors can compare the returns on projects that have similar levels of risk, regardless of how they are financed. This allows for a more accurate comparison of investment opportunities and can help investors make more informed decisions about where to allocate their capital.

How to consider levered vs. unlevered return in a decision-making process?

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