From thinking-frameworks-skills
Evaluates investment projects using NPV, IRR, return on capital analysis, EVA, and risk-adjusted discount rates. Checks if ROC exceeds WACC for capital budgeting decisions.
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Scenario: Netflix-style international expansion -- "Netflix Fit" fitness equipment and subscription service
Project scope: $2.4B upfront manufacturing investment, 10-year depreciable life (salvage $400M), global rollout with 60% of revenue outside North America.
Cash flow identification:
Discount rate adjustment:
Results:
Copy this checklist and track your progress:
Project Investment Analysis Progress:
- [ ] Step 1: Define project scope and identify cash flows
- [ ] Step 2: Determine project-specific discount rate
- [ ] Step 3: Compute NPV and IRR
- [ ] Step 4: Assess value creation (ROC vs WACC, EVA)
- [ ] Step 5: Run sensitivity analysis
- [ ] Step 6: Make recommendation (invest / defer / reject)
Step 1: Define project scope and identify cash flows
Map all incremental cash flows attributable to the project. Exclude sunk costs (already spent regardless of decision). Include opportunity costs (forgone alternative uses of resources). Capture side effects such as cannibalization of existing products or synergy with other divisions. See resources/template.md for the year-by-year cash flow input template.
Step 2: Determine project-specific discount rate
If the project has different risk characteristics than the company overall, compute a project-specific discount rate. For international projects, add a revenue-weighted country risk premium to the base WACC. For projects in a different industry than the parent, use a bottom-up beta from peers in that industry. See resources/methodology.md for regional risk adjustment and project beta estimation.
Step 3: Compute NPV and IRR
Discount incremental after-tax cash flows at the project-specific hurdle rate. Compute NPV as the sum of discounted cash flows minus the initial investment. Find the IRR (discount rate at which NPV equals zero). See resources/template.md for the NPV/IRR calculation worksheet.
Step 4: Assess value creation (ROC vs WACC, EVA)
Compute the project's return on invested capital once it reaches steady state. Compare ROC to the project's WACC. Calculate EVA as (ROC - WACC) x Invested Capital. A project creates value when ROC exceeds WACC. See resources/methodology.md for the economic value added framework.
Step 5: Run sensitivity analysis
Identify the 3-5 assumptions that most affect NPV (typically: market share, pricing, discount rate, cost inflation, project life). Vary each independently and observe the impact on NPV and the invest/reject decision. See resources/template.md for the sensitivity grid template.
Step 6: Make recommendation (invest / defer / reject)
Synthesize NPV, IRR, ROC/EVA, and sensitivity results into a clear recommendation. If NPV is positive across plausible scenarios, recommend investing. If NPV is positive only under optimistic assumptions, recommend deferring until uncertainty resolves. If NPV is negative under most scenarios, recommend rejecting. Validate using resources/evaluators/rubric_project_investment_analyzer.json. Minimum standard: Average score of 3.5 or above.
Pattern 1: Domestic Expansion
Pattern 2: International / Emerging Market Project
Pattern 3: Existing Investment Assessment (Backward-Looking)
Exclude sunk costs: Money already spent and unrecoverable is irrelevant to the go/no-go decision. The $250M already spent on R&D in the Netflix Fit example does not factor into the NPV calculation, even if it feels psychologically relevant.
Include opportunity costs: If the project uses resources that could generate value elsewhere (e.g., excess studio capacity that could be rented out), the forgone revenue is a real cost of the project.
Use project-specific discount rates when risk differs from the company average: A technology company entering the restaurant business faces restaurant-level risk on that project, not tech-level risk. Use bottom-up beta from the project's industry.
Be cautious with IRR: IRR can be misleading when cash flows change sign more than once (producing multiple IRRs). It also cannot rank mutually exclusive projects of different scale -- a small project with 50% IRR may create less value than a large project with 20% IRR. When in doubt, rely on NPV.
For mutually exclusive projects, choose highest NPV, not highest IRR: IRR does not account for scale. A $1M project earning 30% IRR creates less value than a $100M project earning 15% IRR.
Include all side effects in cash flows: Cannibalization (new product steals sales from existing product) reduces incremental cash flows. Synergy (new product boosts demand for existing products) increases them. Both belong in the analysis.
Match cash flow currency to discount rate currency: If cash flows are in local currency (e.g., Indian rupees), discount at a rupee-denominated rate. If cash flows are converted to USD, discount at a USD rate with country risk premium.
Common pitfalls:
Key formulas:
NPV = Sum of [CF_t / (1 + r)^t] for t=0 to n
where CF_0 is typically the initial investment (negative)
and r is the project-specific discount rate
IRR = discount rate r such that NPV = 0
ROC (Return on Capital) = After-tax Operating Income / Invested Capital
ROE (Return on Equity) = Net Income / Book Value of Equity
EVA (Economic Value Added) = (ROC - WACC) x Invested Capital
Depreciation Tax Shield = Depreciation x Tax Rate
After-tax Salvage = Salvage Value - Tax Rate x (Salvage - Book Value)
Incremental Cash Flow = After-tax Operating Income
+ Depreciation
- Capital Expenditure
- Change in Working Capital
+ After-tax Salvage (in final year)
Project-Specific WACC = Base WACC + Revenue-Weighted Country Risk Premium
Decision rules:
| Metric | Invest | Defer | Reject |
|---|---|---|---|
| NPV | > 0 across scenarios | > 0 base case, < 0 pessimistic | < 0 in most scenarios |
| IRR | > hurdle rate | Near hurdle rate | < hurdle rate |
| ROC vs WACC | ROC > WACC | ROC near WACC | ROC < WACC |
| EVA | Positive | Near zero | Negative |
Key resources:
Inputs required:
Outputs produced:
project-investment-analysis.md: Complete analysis with cash flow table, discount rate computation, NPV, IRR, ROC, EVA, sensitivity analysis, and recommendation