1. Defining Relevant Cash Flows
When building a financial model for project appraisal, analysts must evaluate only incremental, after-tax cash flows. The fundamental rule is: “Does this cash flow occur only if we accept the project?”
Critical Evaluation Parameters
- Sunk Costs: Costs already incurred in the past that cannot be recovered (e.g., a market research study done last year). Sunk costs must be completely excluded from the analysis.
- Opportunity Costs: The cash forgone by using an asset for this project instead of its next best alternative (e.g., using land the firm already owns that could be sold for $1M). Opportunity costs must be included as a cash outflow.
- Side Effects / Externalities: Erosion or cannibalization occurs when a new product reduces the sales of an existing product line. These negative externalities must be subtracted from the projected cash flows.
2. Operational Cash Flow Formula
OCF = (Revenues − Expenses − Depreciation) × (1 − T) + Depreciation
Where: T = Corporate Tax Rate. Note: Depreciation is added back because it is a non-cash expense that provides a critical tax shield.
Where: T = Corporate Tax Rate. Note: Depreciation is added back because it is a non-cash expense that provides a critical tax shield.
3. Risk Adjustments in Capital Budgeting
- Sensitivity Analysis: Changing one variable at a time (e.g., price drops by 10%) to see its exact impact on project NPV.
- Scenario Analysis: Changing multiple variables simultaneously to evaluate specific economic states (“Best Case”, “Base Case”, “Worst Case”).
- Risk-Adjusted Discount Rate (RADR): Higher-risk projects are assigned a higher discount rate, raising the hurdle required to achieve a positive NPV.
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