Free and Clear Return
Free and Clear Return, also known as the Unlevered Cash-on-Cash Return, is the total unlevered (before debt) pre-tax cash flow of a project divided by the total capital invested, typically expressed as a percentage on an annual basis. It represents the return on an investment without considering any debt financing.
Calculation
The formula for Free and Clear Return is:Free and Clear Return = (Unlevered Pre-Tax Cash Flow / Total Capital Invested) x 100
Unlevered vs. Levered Cash Flow
- Unlevered Cash Flow:
- Represents the cash flow of a project before considering debt payments
- Useful for comparing projects with different capital structures
- Provides a clear picture of the project’s operating performance
- Levered Cash Flow:
- Represents the cash flow after debt payments
- Reflects the actual return to equity investors
- Affected by the financing structure of the project
The Free and Clear Return helps in understanding the underlying performance of an investment without the impact of financing decisions.
What Entrepreneurs Should Take From This
Assess Core Profitability First
Before considering financing options, evaluate the free and clear return to understand the inherent profitability of the investment or project.
Understand the Impact of Leverage
- Enhanced Returns: Leverage can amplify returns on equity when the investment’s return exceeds the cost of debt.
- Increased Risk: Debt obligations introduce fixed costs that must be met regardless of business performance, increasing financial risk.
Make Informed Financing Decisions
- Cost of Debt vs. Return on Investment: Ensure that the cost of borrowing is lower than the unlevered return to benefit from leverage.
- Cash Flow Adequacy: Confirm that cash flows are sufficient to cover debt service even in downside scenarios.
Risk Management
- Balance Growth and Stability: While leverage can accelerate growth, it’s essential to maintain a balance to avoid overextending financially.
- Contingency Planning: Prepare for potential fluctuations in income that could affect the ability to service debt.
- Risk Assessment: A higher Free and Clear Return may indicate a more robust investment that can withstand financial stress better.
Strategic Alignment
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Long-Term Goals: Align financing decisions with the long-term objectives of the business, considering both the potential rewards and risks. While leveraged returns may be higher in the short term, the Free and Clear Return provides insight into the long-term sustainability of an investment.
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Investor Expectations: If seeking external investment, understand that investors may have preferences regarding leverage and return profiles.
Comparative Analysis
Free and Clear Return allows for a more accurate comparison between different investment opportunities, regardless of their financing structures.
Financing Decisions
By understanding the Free and Clear Return, entrepreneurs can make more informed decisions about whether and how much to leverage an investment.
Screening Tool
It serves as a useful initial screening tool for potential investments, especially for those focused on stable cash flow rather than appreciation.
Holistic Evaluation
Entrepreneurs should use Free and Clear Return in conjunction with other metrics like Internal Rate of Return (IRR) and Equity Multiple for a comprehensive evaluation.
Industry Benchmarking
It allows for comparison against industry standards and helps in setting realistic return expectations.
Capital Structure Optimization
Understanding the difference between Free and Clear Return and levered returns can help in optimizing the capital structure of an investment.