A practical example

In this article you’ll find
• how to evaluate a new opening through cash flows and discounted value
• how probability-weighted scenarios improve investment decisions
• why uncertainty must be incorporated into retail expansion analysis

In the previous article, we introduced a framework to evaluate a new opening through cash flows, probabilities and discounted value. The objective here is not to build a perfect model, but to illustrate how the logic can be applied in practice.

Initial investment

Assume a new food retail store with the following initial investment:

  • fit-out and equipment → €200k
  • pre-opening costs → €30k
  • initial working capital → €20k

Total invested capital → €300k

Assume:

  • investment horizon → 6 years
  • WACC → 10%

The discount rate reflects the expected return required by providers of capital for a small retail operation with execution risk, local market exposure and uncertain long-term performance.
In practice, the rate incorporates:

  • capital structure → the relative weight of equity and debt used to finance the investment
  • cost of debt → typically between 3% and 8%, depending on leverage and financing conditions
  • required return on equity → often above 10–12% for small retail operations exposed to execution and market risk

Estimating cash flows

The next step is to estimate the cash flows generated by the store over the selected investment horizon. Two approaches can be used:

  • Free Cash Flow to the Firm (FCFF)
  • Free Cash Flow to Equity (FCFE)

FCFF represents the cash flow generated by operations before debt service and available to all providers of capital. A simplified structure can be expressed as:

FCFF=NOPAT+depreciation and amortization−changes in working capital−capital expenditures+proceeds from asset disposals (if any)FCFF = NOPAT + depreciation\ and\ amortization – changes\ in\ working\ capital – capital\ expenditures + proceeds\ from\ asset\ disposals\ (if\ any)

FCFF = NOPAT + depreciation and amortization – changes in working capital – capital expenditures + proceeds from asset disposals (if any)

FCFE represents the cash flow available to equity holders after debt-related obligations. A simplified structure can be expressed as:

FCFE = FCFF – interest expenses net of tax benefit – debt repayments + new debt issued

Once estimated, future cash flows must be discounted to reflect the time value of money and the risk associated with the investment.

FCFF is typically discounted at the Weighted Average Cost of Capital (WACC), while FCFE is discounted at the required return on equity (Ke).

The sum of the projected cash flows over the selected investment horizon, discounted at the appropriate rate, represents the present value of the business.

When using FCFF, the result reflects the value available to all providers of capital.
When using FCFE, the result reflects the value available to equity holders.

Scenario construction

Instead of relying on a single forecast, three scenarios are defined.

1) Downside scenario

Assumptions: weak customer traffic, slower ramp-up and lower operating efficiency.
Estimated present value of future FCFF: €350k
Probability assigned: 30%
Probability-weighted value: €105k

2) Base case scenario

Assumptions: stable traffic, expected operating margins and normal execution quality.
Estimated present value of future FCFF: €700k
Probability assigned: 50%
Probability-weighted value: €350k

3) Upside scenario

Assumptions: stronger sales density, faster maturity and better operating leverage.
Estimated present value of future FCFF: €1.1M
Probability assigned: 20%
Probability-weighted value: €220k

Expected value

The probability-weighted expected value becomes:

  • downside → €105k
  • base case → €350k
  • upside → €220k

Total expected value: €675k

Comparing value and investment

The expected value (€675k) is compared with the invested capital (€300k).
Value exceeds investment by:

2.25x → margin of safety = ( €675k – €300k ) : €675k = 55%

This implies:

  • positive expected value
  • a margin of safety above the minimum threshold discussed previously (≥ 50%)
  • sufficient protection against moderate deterioration in assumptions

What this example shows

The objective of the framework is not precision in absolute terms. The objective is to:

  • structure uncertainty
  • separate possible outcomes
  • compare value against invested capital
  • make assumptions explicit

The quality of the decision depends less on forecasting accuracy, and more on the coherence of the assumptions and the consistency of the evaluation process.

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