Opportunity cost in financial modeling
Hi all,
Assuming company is looking to convert a factory (say manufacturing biscuits) into one that processes/manufactures a completely different product (say icecream, so no longer can produce biscuits) (in short a totally different purpose).
Question is in the financial modeling for the icecream purpose/usage (npv/irr), does the opportunity cost of forgoing the cashflows from the existing usage (biscuits) need to be built into the model?
It naturally should.
What I have seen is that you will model the company as a whole and therefore you can assess what the upside would be to the valuation / returns from undergoing this project vs. status quo (biscuits in your example). So you will have a model which includes the biscuit division cashflows under a status quo or 'Base Case' scenario. This will produce an EV at a given discount rate (or an IRR at a given price) which is your valuation.
You would then run a scenario where you convert the biscuit division to an ice-cream division (e.g. factor in capex, production down time, incremental revenue and the lost cashflows from the biscuit etc.). The aim should be that the project as a whole is NPV positive (i.e. increases your EV). If it is then it is worthwhile investing in as it is value accretive relative to your current Base Case (no conversion to ice-cream).
The term 'opportunity cost' isn't really thrown around a lot, more a case of whether a given project is NPV positive or not which take into account the cost of foregoing some existing cashflows as part of the investment.
"Incremental FCF Analysis"
When you know what you currently do and what it takes, and what you WANT to do in a future state, but only have a guestimate as to the impact on the financial statements by shifting.
Basically, you don't NEED to know it costs, call it, $1 to produce a biscuit and $3 to produce ice cream, just that ice cream will likely be incrementally more than a biscuit. Apply that out to all relevant P&L items.
would it be feasible to do a fcff for the new project (icecream) and subtract the fcff of the existing biz (biscuit) to derive the incremental cfs (fcff) for computation of the returns metrics (npv/irr/etc)?
Assumenda quo quaerat sunt repudiandae atque repellat autem autem. Vel fuga et autem perferendis fugiat et magnam. Ea dicta deleniti est.
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